Active Vs Passive Investing Strategies

Take a look at this guide to better understand what is the difference between active and passive investing.

Updated: January 3, 2024
Matt Crabtree

Written By

Matt Crabtree

 
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In the investment world, there are a variety of different strategies that you can consider for your portfolio. In fact, you could even incorporate multiple strategies or focus on specific strategies in different accounts. It’s entirely up to you how you choose to invest, but understanding the varying strategies can certainly be helpful. 

Most strategies fall either into active or passive investment strategies. It’s important to know the difference. This will also be pertinent information when it comes to working with things like mutual funds or ETFs, as these may be actively or passively managed as well. 

What’s the difference between active and passive investing? Take a look at this guide to better understand what these terms mean and the difference in the strategies. 

Active Vs Passive Investing Strategies — Active Investing

Active investing requires a far more active approach to managing and monitoring a portfolio. This means it’s going to be more hands on for whomever the manager of this portfolio might be. In some cases, it may be the manager of a mutual fund

With active management, there is generally a portfolio manager who is tasked with overseeing the entire approach and strategy of the portfolio. It is the manager’s responsibility to ensure investments meet the strategies and defined goals.

They are the ones tasked with trying to meet or pass the index measurements as well. 

In general, the active management approach is meant to beat the stock market and not just match it. That one portfolio manager probably won’t be working alone. They will work in coordination with a team of analysts and traders for the entire management of a fund or portfolio. 

Whoever is in charge of managing an active portfolio typically has to be good at gauging when to buy and sell and when to take a risk. They need to be right as much as possible to make the portfolio successful. 

Top Advantages of Active Investing

Whether you choose to utilize funds that are active or passive is entirely up to you. It will depend on your risk assessment, as well as your goals. There isn’t necessarily a right or wrong answer. But there are advantages and disadvantages to know about. 

These are the top advantages of using active investing. 

✔️ Flexibility

✔️ Protective hedging

✔️ Tax management

✔️ Upward potential

✔️ Risk management

Flexibility is perhaps one of the major advantages of an active investment strategy. The reason for this is that the active managers can get in or out of assets whenever they see fit.

As an active management tool, they can adjust the portfolio as needed and there doesn’t have to be approval to do so. Of course, they have to act in line with the strategy of the portfolio, but other than that they have free reign. The value of choice can be huge. 

Active funds have the ability to take a little bit more risk in some scenarios, because they have the flexibility to hedge those risks. They can set certain hedging setups within the portfolio to help protect the assets there.

It’s all about limiting the losses in this case. The hedging protection and active management allow them to pull the plug on an asset immediately to move things around. 

In some cases, an active investment strategy may help with tax management. When an active manager is overseeing an individual portfolio, they can cater the choices of that portfolio to best meet the client’s needs, and that includes limiting capital gains. 

The potential to experience upward gains in the market is certainly nice. Portfolio managers on an active strategy typically strive to beat the market. Their goal is to reach for the start, but to do so without exposing you to more risk than you can tolerate. 

And finally, active funds have risk management advantages because if something is going wrong or there are downward indicators, the have the authority to exit a fund or asset in order to better protect the portfolio from a downward spiral. 

Top Disadvantages of Active Investing

There are always disadvantages to consider alongside the advantages. It’s part of setting clear expectations so you know exactly what you are working with. When it comes to active management, you could see some negatives in certain areas. 

❌️ Higher fees

❌️ Reliance on manager

❌️ Risk potential

Active management portfolios have naturally higher fees than a passively managed portfolio. It doesn’t matter if you’re looking at an actively managed mutual fund or whether you’re considering setting up an actively managed portfolio with an advisor.

Both of these will have higher fees than anything passively managed. 

Of course, this makes sense. It’s only fair that if the management is far more hands on and intensive in nature, then it’s going to cost more to oversee it. The fees are also higher because the cost of trading will be higher.

Since assets are actively bought and sold rather than bought and held, there are going to be more costs to management. So those expensive expense ratios are two-fold. At the same time, they make sense. You just know you’re going to pay more for this type of investment strategy. 

Another disadvantage is that your success is completely related to the decisions of the portfolio manager. They have the ability to buy any type of investment and make the decisions for your fund or your account. They are in control.

Now, this likely won’t be a problem, but it might be if you don’t agree with something they purchase or they happen to make a poor decision. You’re putting it in their hands and releasing the control to them. 

The risk potential is mostly related to relying on the portfolio manager as well. You can’t control your risk exposure in active management. That’s left up to the portfolio manager. They may be skilled and knowledgeable, but it doesn’t negate the risk or the possibility of them making a decision that doesn’t pan out. 

Active Vs Passive Investing Strategies — Passive Investing

Passive investing is more a set it and forget it type of strategy. While there may be some basic management happening, it won’t be actively monitored and managed like an active portfolio is. Most passive investment strategies utilize a long-term approach where you make a sound decision, invest your funds, and then just let it be. 

In a portfolio that is set up with passive investment strategies, there will be far less activity, making it more affordable to manage. You can purchase passively managed funds with low expense ratios.

You can also utilize your own passive strategies or hire an advisor to passively manage. 

A passively managed fund or portfolio is just going to be checked or rebalanced 2-4 times a year, rather than being constantly monitored. The intent is to make as few changes as possible within the portfolio, relying more on long-term holdings. 

If active is the approach that you choose to utilize, you will want to make your investments and then just let it be. Worrying about it or monitoring it constantly would negate the purpose of long-term and passive management. 

Index funds are a common choice in passive investing. The reason for this is they are tracked by the index and resolve to match it, or at least get close. They are inexpensive and serve the purpose of a passive approach. 

Top Advantages of Passive Investing

There are both pros and cons to taking advantage of a passive approach, just as there was with an active approach. Passive won’t be the right fit for every person or every portfolio out there. It’s much the same as active, which also won’t suit every investor’s needs. 

When it comes to advantages, these are the top advantages of passive investing. 

✔️ Low expenses

✔️ Simple transparency

✔️ Buy and hold

✔️ Tax efficient

Since passively managed portfolios don’t require a lot of trading or a lot of work to manage, they are usually pretty cheap to buy and maintain. The expense ratios are going to be downright cheap when you compare them to the expenses of actively managed portfolios. You’re looking at fee points that are around 0.10-0.40% in most cases.

If they are much higher than that, you are probably overpaying. 

The expenses are much lower because even though they are monitored and occasionally rebalanced, they are far less work heavy. They don’t have to be constantly watched and they have very little trading, aside from rebalancing periods. 

They choose an index to use as their benchmark, and then they closely follow that benchmark in the way that the fund is managed and monitored. There isn’t a lot of work to be done so it’s more affordable to manage and provide services to the holders. 

Transparency is nice as well. You know that this fund is going to remain static for the most part. It generally follows the index, so while the holdings may vary slightly, they are going to be pretty similar to hit the index measurements.

You always know what the holdings are. They can be changed, but they are changed far less often and generally have to be approved for changes. 

This is a buy and hold strategy so you take your pick, you make the purchase, and then you just let it be. Don’t worry about it, don’t fret about it. You don’t have to worry about a wayward manager wreaking havoc either. 

Finally, since this is a buy and hold strategy, you aren’t going to have to worry about capital gains all that often as you would in an actively managed account. The gains will only come up when it’s time to sell out of the fund in the future. 

Top Disadvantages of Passive Investing

Just as there are positive, there are disadvantages to be aware of as well. These are some of the disadvantages of a passive investment. 

❌️ Returns may be lower

❌️ Limited flexibility

❌️ Lack of hedging

In a passive fund, the returns can be far lower. You will have returns of some sort, but an actively managed asset can generally outdo them any day. The reason for this is they aren’t set up to outperform, where active assets are. Instead, they are set up to follow and match the index, so it’s a totally different approach. 

With a passively managed portfolio, there isn’t a lot of flexibility. Passive funds can only be changed at certain times and how they can be adjusted might also be limited. A set fund or portfolio is going to be limited to whatever it is tracking against, not allowing for much variation. It’s never customized or personalized for an investor. 

A passive fund may have limited hedging as, meaning if the market goes down you just have to ride it out. The managers are not able to simply pick up on a downturn and reallocate the funds. Remember it’s set to forget so they aren’t even really watching the downturns. Instead the strategy is to hold through it and wait for the upside recovery. 

Active Vs Passive Investing Strategies — Review

In short, active vs passive is pretty self-explanatory based on the terminology. Anything that is active has an active manager looking out for the best interest of the portfolio or the asset.

They tend to cost more and have more flexibility. 

A passive asset or portfolio is a buy and hold approach in which they match against the index and then just let it be for the long haul. These are not so flexible but generally do well and they are more affordable to invest in. 

Final Thoughts

Choosing an active or passive investment strategy is going to be dependent upon your market tolerance and your goals for your investments and portfolio. You may choose to use some of each even and see where it gets you. They are both unique and have their own array of benefits that investors can appreciate. 

Which strategy will you use?

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