The difference between active and passive investing
Editorial staff, J.P. Morgan Wealth Management
- Active investing seeks to outperform – or “beat” – the benchmark index, while passive investing seeks to track the benchmark index.
- Active investing is favored by those who seek to have a team monitoring the portfolio with expertise in that respective asset class, while passive investing is often used by investors with a long-term horizon.
- Active investing strategies usually have a higher fee structure than passive investing strategies.
- Historically, research has shown that very few active investing strategies are able to “beat” the market or benchmark on a consistent basis.
What is active investing?
Active investing refers to taking a more proactive approach to the management of an investment portfolio. The goal is to outperform – or “beat” – the market. This is usually measured by comparing the portfolio’s returns with those of a benchmark, often a broad-based market index like the S&P 500 or some other index whose asset mix is similar to that of the portfolio’s objective.
While there will be strategies and guidelines for achieving the desired outcome, there is a discretionary component to this style of investing that often results in more turnover (buying and selling) in the portfolio. This invariably involves humans, which inevitably translates into a higher fee structure. This expense is justified as long as the performance is commensurate to the point where it can absorb these higher costs while still delivering “market-beating” results.
Active investing also requires portfolio managers who have a thorough understanding of the markets, especially the relationship between their portfolio’s asset mix and the overall economy. Active portfolio managers must also be cognizant of other factors, like geopolitical events, that could potentially affect their holdings, and they must monitor their portfolios constantly.
The most effective active investing managers will have a skill set that includes a breadth of investment knowledge, years of experience, an understanding of effective risk-management techniques and an analytical mindset that allows them to act decisively on well thought-out strategies. The most obvious example of entities that practice active investing strategies are hedge funds.
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What is passive investing?
Passive investing is often utilized by investors with a long-term horizon. The core tenets are that – over a multi-decade time interval – the market will be higher and will outperform the active investing strategy. Basically, a passive investor believes that it is not possible to consistently beat the returns generated by the market as a whole over the long run.
The goal is to track – or match – the returns of the suitable benchmark index, not to “beat” it. Typically, this objective is accomplished by investing in index funds. These funds are composed of assets, like stocks and bonds, that are part of the benchmark index. Passive investing effectively removes the discretionary component that is inherent in the active investing strategy, which makes passive investing more amenable to automation, albeit with some oversight.
Although active investing may also adopt a buy-and-hold strategy, this approach is often synonymous with passive investing. As such, the turnover is limited with a passive strategy, which reduces the transaction costs and, in turn, results in a lower fee structure.
Active vs. passive Investing
Active investing | Passive investing |
|---|---|
Aim | |
Active investing aims to outperform a specific benchmark, such as a market index, mutual fund or ETF, through strategic asset allocation and market timing. | Passive investing generally aims to mirror the performance of the market or a target benchmark and typically involves buying a market index or holding a specific group of assets for longer periods. |
Management style | |
Active investment, be it a professionally managed fund or your individual portfolio, is characterized by frequent decisions about which securities to buy, hold or sell. These decisions are based on research, market forecasts and the judgement of the individual. | Passive investment generally incorporates more automation and buy-and-hold strategies designed to mimic a benchmark index. This means less frequent decision-making and less hands-on management. |
Fees and costs | |
With active investing, fees are usually higher due to the costs associated with researching individual investments, the frequent buying and selling of securities and various management expenses. | Passive funds, such as index funds, typically have lower expense ratios. This is because they typically engage in less trading, resulting in lower commission costs and fewer active management decisions. |
Potential returns | |
A primary selling point for active investing is the potential to outperform the market. It is, however, worth noting that most active investing strategies fail to beat average market returns, especially after accounting for fees. | Passive funds aim only to mirror market performance. However, some research has shown that passive investment often yields higher returns in the longer run than active investment strategies. |
Risk profile | |
Under skilled managers, active investment strategies may be able to better mitigate market downturns than passive ones. | Passive investment strategies reflect both a market’s downturns and its upturns. Over long periods, markets have historically trended upwards, and thus some consider passive investment less volatile across a longer timeline. |
Advantages and disadvantages of active investing
There are advantages and disadvantages to either mode of investing. The main advantage of active investing lies in its premise: “beating” the market. This is attractive to the segment of the investing community that views the market as rewarding those that take on more risk. For these investors, the lure of outperforming the benchmark index is a deciding factor in choosing this type of investing, and they are willing to pay a premium for this.
Another advantage is the bespoke nature of active investing, where the asset mix can be tailored to align with the investor’s goals more closely. Additionally, active monitoring of the portfolio should offer more downside protection from market crashes, as the manager should be able to, in theory, mitigate the extreme drawdowns.
Active investing has its disadvantages as well. Chief among them is that the portfolio’s performance is dependent on the skill of the manager. Another major obstacle is the higher fee structure involved. Not only must active managers “beat” the returns of the benchmark index, they have to outperform it by a large enough margin to justify their fees. Research has shown that, historically, very few active investing strategies are actually able to achieve this on a consistent basis.
Advantages and disadvantages of passive investing
The main advantage of passive investing is the lower – in some cases much lower – fee structure. Since there is great deal of automation involved, passive strategies do not involve certain expenses, like paying the managers, that active investing strategies incur. Additionally, an investor is exposed to the market – or the particular market segment that is based on the benchmark index – at all times. This is in line with the passive investor’s ethos that the market cannot be “beaten.” This also affords a level of transparency, as the investor always knows the asset composition of their portfolio.
The main disadvantage is the lack of protection from an extreme event, like a market crash. Since the portfolio tracks the market, a severe decline in the latter will also affect the former. Also, there isn’t the leeway for configuring the investor’s portfolio to closely match their investing goals. A poorly performing asset or segment will remain in the portfolio until, and unless, the benchmark index makes a change.
Is one strategy better than the other?
Active investing is favorable for investors who want to risk more for a potentially higher reward and are not averse to the higher fees they might incur. It is also attractive for those who want more oversight of their portfolio in case of an extreme event that might adversely affect it.
Passive investing is for the investor who is mindful of the cost and is willing to let the long-term market be the guide to their investment philosophy. These individuals are of the belief that, over the long run, this style of investing will help them in achieving their investing goals. The secular bull market that has been ongoing in the U.S. for the better part of 30+ years would lend credence to this school of investing thought.
So, there is not a definitive answer as to which style is better for the average investor. But, then again, it doesn’t have to be a binary choice. In the spirit of diversification, an investor might choose to incorporate both active and passive investing strategies into their portfolio. Ultimately, it comes down to what their investment goals are – and it is always advisable to speak to a licensed financial professional to get clarity on this.
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Editorial staff, J.P. Morgan Wealth Management