Active vs Passive Investing: Differences Explained

Passive investments are funds intended to match, not beat, the performance of an index. Active management requires a deep understanding of the markets and how assets move based on what’s happening in the economy, the rest of the market, politics, or other factors. Portfolio managers use their experience, knowledge, and analysis to make choices about what to buy or sell in the portfolio.

You could also avoid treating the active vs. passive investing debate as a forced dichotomy and select the best funds in either category that suit your goals. •   Whereas a passive strategy is designed to follow one market sector index (e.g. the performance of large cap U.S. companies via the S&P 500® index), an active manager can be more creative and is not limited to a single sector. The following proposition characterizes the portfolio holdings of the informed investors.

active vs passive investing studies

Contrast that with expense ratios for passive index equity funds, which averaged just 0.08% in 2018, down from 0.27% in 1997. They can be active traders of passive funds, betting on the rise and fall of the market, rather than buying and holding like a true passive investor. Conversely, passive investors can hold actively managed funds, expecting that a good money manager can beat the market. Active investing means investing in funds whose portfolio managers select investments based on an independent assessment of their worth—essentially, trying to choose the most attractive investments. Generally speaking, the goal of active managers is to “beat the market,” or outperform certain standard benchmarks. For example, if you’re an active US equity investor, your goal may be to achieve better returns than the S&P 500 or Russell 3000.

There are a few important differences to keep in mind when it comes to active vs. passive investing. Almost 81% of large-cap, active U.S. equity funds underperformed their benchmarks. Led by a former hedge fund PM (Maverick, Citadel, DE Shaw, Schonfeld), this program begins where financial modeling training ends — with a deep-dive into how buy-side analysts build financial models to make key investment decisions. The S&P 500 index fund compounded a 7.1% annual gain over the next nine years, beating the average returns of 2.2% by the funds selected by Protégé Partners. Return and principal value of investments will fluctuate and, when redeemed, may be worth more or less than their original cost.

Regarding near-arbitrage profits, systematic evidence is rare, but it is telling that no outside investors are allowed into the famous Medallion Fund of Renaissance Technologies, which has reportedly delivered very high returns with a remarkable consistency. This impressive performance suggests a focus on micro strategies that hedge out almost all risk, so the strategy’s limited scale is consistent with the model. Stambaugh (2014) also considers trends in the investment management sector based on a different framework where the key driving force is a reduction in the amount of noise trading. As noise trading declines in his model, the allocation to, and the performance of, active managers both decline. Hence, this model cannot explain the finding of Cremers et al. (2016) discussed above, namely, that the size and performance of active management move in opposite directions (but the model can explain a number of other phenomena). This figure shows properties of the model implied by different values of the percentage cost of passive investment, fp% (on the x-axis, in percent).

As a group, actively managed funds, after fees have been taken into account, tend to underperform their passive peers. While actively managed assets can play an important role in a diverse portfolio, Wharton faculty involved in the program say that even large investors often do best using passive investments for the bulk of their holdings. Active investing, they say, can nonetheless be useful with certain portions of the portfolio, such as those invested in illiquid or little known securities, or holdings tailored to a specific purpose such as minimizing losses in a down market. You can do active investing yourself, or you can outsource it to professionals through actively managed mutual funds and active exchange-traded funds (ETFs).

  • These investors tend to rely on fund managers to ensure the investments held in the funds are performing and expect them to replace declining holdings.
  • When you own tiny pieces of thousands of stocks, you earn your returns simply by participating in the upward trajectory of corporate profits over time via the overall stock market.
  • In summary, we have seen how to make Samuelson’s dictum precise as the statement that active investors make factor-neutral portfolios most efficient, while leaving the factor portfolio as the most inefficient portfolio.
  • Morgan Stanley Smith Barney LLC, its affiliates and Morgan Stanley Financial Advisors do not provide legal or tax advice.

You can buy shares of these funds in any brokerage account, or you can have a robo-advisor do it for you. Passive investing and active investing are two contrasting strategies for putting your money to work in markets. Both gauge their success against common benchmarks like the S&P 500—but active investing generally looks to beat the benchmark whereas passive investing aims to duplicate its performance. While passive funds still dominate overall due to lower fees, some investors are willing to put up with the higher fees in exchange for the expertise of an active manager to help guide them amid all the volatility or wild market price fluctuations. When you own fractions of thousands of shares, you earn your returns simply by participating in the upward trajectory of corporate profits over time via the overall stock market.

active vs passive investing studies

Please refer to Titan’s Program Brochure for important additional information. Before investing, you should consider your investment objectives and any fees charged by Titan. The rate of return on investments can vary widely over time, especially for long term investments.

The Motley Fool reaches millions of people every month through our premium investing solutions, free guidance and market analysis on, top-rated podcasts, and non-profit The Motley Fool Foundation. Get instant access to video lessons taught by experienced investment bankers. Learn financial statement modeling, DCF, M&A, LBO, Comps and Excel shortcuts. Thus, downturns in the economy and/or fluctuations are viewed as temporary and a necessary aspect of the markets (or a potential opportunity to lower the purchase price – i.e. “dollar cost averaging”). In other words, most of those who opt for passive investing believe that the Efficient Market Hypothesis (EMH) to be true to some extent.

Our findings help explain the rise of delegated asset management and the resultant changes in financial markets. Passive managers seek to choose the best possible portfolio conditional on observed prices, but not conditional on the information that active managers acquire. One may wonder whether passive managers should choose the “market portfolio” (the market-capitalization weighted portfolio of all assets), which is the standard benchmark in the capital asset pricing model (CAPM). Bridging the REE literature and the CAPM, Admati (1985) points out that the unconditional expected market portfolio is generally not the optimal portfolio for uninformed investors. Indeed, uninformed investors can do better by using the information reflected in prices, as shown theoretically and empirically by Biais, Bossaerts, and Spatt (2010).

A portfolio manager usually oversees a team of analysts who look at qualitative and quantitative factors and then utilizes established metrics and criteria to decide when and if to buy or sell. Over the past decade, data reveals a consistent trend of active large-cap funds underperforming their respective benchmarks. According to a study by S&P Global, approximately 94% of large-cap funds in India have failed to beat their benchmark indices over five years. At WealthDesk, we can offer you a readymade WealthBasket consisting of stocks or ETFs reflecting an investment strategy or theme designed explicitly by the SEBI-approved investment professionals and make your investment journey hassle-free. •   Passive strategies are more vulnerable to market shocks, which can lead to more investment risk. Because index funds simply track an index like the S&P 500 or Russell 2000, there’s really no mystery how the constituents in the fund are selected nor the performance of the fund (both match the index).

Some might have lower fees and a better performance track record than their active peers. Remember that great performance over a year or two is no guarantee that the fund will continue to outperform. Instead you may want to look for fund managers who have consistently outperformed over long periods. Some investors have built diversified portfolios by combining active funds they know well with passive funds that invest in areas they don’t know as well.

Since passive funds and indexes have incentives to mimic the optimal uninformed strategy, these results can be seen as predictions for which types of indexes should emerge as the most successful. The first part of Assumption 2 simply says that fundamentals and signal noise have the same risk structure (which can also hold under Assumption 1). The second part, which is more unusual, Active vs passive investing says that the inverse of the variance-covariance matrix of the supply noise also shares this structure.14 Assumptions 1 and 2 are both satisfied if all shocks are i.i.d. across assets, but otherwise they are different. We focus on Assumption 1, as it is the more standard and more realistic assumption. Assumption 2 is to be thought of as a generalization of the i.i.d.-shock case.