There has been a lot of debate over whether active funds or passive funds are "better," but the answer is that they can serve different purposes. Investors care most about which type performs better, meaning which has higher returns, but risk is another important consideration.

In short, actively managed funds have investment managers or management teams that pick stocks or securities that they expect to outperform their benchmark or otherwise add value to the overall portfolio. Passively managed funds, on the other hand, track an index and don't have managers making investment decisions. Each of those approaches comes with pros and cons that investors should know about.

Below I'll discuss some of the most important differences between active and passive funds. Note: Throughout this article I broadly refer to "funds," but I don't make a distinction between mutual funds and exchange-traded funds (ETFs). There are both passive and active mutual funds and ETFs, though most ETFs are passive, while mutual funds are more often actively managed.

stock quotes on digital display

Image source: Getty Images.

How passive funds work

To understand passive funds, you first need to understand a couple of important points about index investing.

There are a little under 4,000 exchange-traded stocks. In the investing world, an index has two main purposes: Measuring the overall stock market's performance and serving as a benchmark for individual investors' portfolio performance. Indexes are like complex averages that reflect how the overall market is doing; theoretically, the average of their performance should mirror the health of the stock market as a whole.

There are several popular U.S. market indexes that measure different collections of stocks:

  • S&P 500: Includes 500 of the largest stocks (by market capitalizations) listed on the New York Stock Exchange (NYSE) and the NASDAQ.
  • Nasdaq Composite: A market cap-weighted index including 3,300 common equities (without going into too much detail, the index includes securities other than common stocks) listed on the NASDAQ stock exchange.
  • Wilshire 5000: Represents the total stock market. It is weighted by market cap and contains over 3,000 securities of all market caps.
  • Russell 2000: Composed of 2,000 of the smallest stocks (by market cap) in the Russell 3000 index.

The above are all stock indexes, though there are also a wide array of bond indexes.

These indexes are used to gauge the overall performance of the market -- or of a particular slice of the market. For example, if the S&P 500 gains 0.8% in a month, while the S&P Small Cap 600 gains 1.7%, you might hear that small-cap stocks outperformed large-cap stocks by 0.9%.

Understanding what indexes are is a big part of understanding what passive funds are and what they do. This is because passively managed funds are often defined by the index they track. For example, a fund that tracks the S&P 500 buys and sells stocks as they are added to and dropped from the S&P 500. Passive funds also buy and sell stocks to maintain the same weighting as the index, which is based on market capitalization in the case of the S&P 500. Some index funds won't hold all of the index's securities but only a subset that should mimic the index's performance.

Because there's less managerial involvement, passive funds generally have lower expense ratios than actively managed funds. Expense ratios can be a significant differentiator between passive funds that track the same index, because the funds will, in theory, have the same returns.

Now to the important part -- returns. Passive funds, at best, will match the performance of the indexes they track. In fact, after fees are taken into account, index funds tend to slightly underperform their benchmarks, whose returns are measured without fees.

Proponents of passive investing say the benefits include lower fees, additional transparency, and the potential for better tax efficiency. Passive funds are more transparent because an index's underlying holdings are easily found online. They're sometimes considered more tax efficient because they may buy and sell securities less frequently than their actively managed counterparts -- although this is not always the case.

How active funds work

While active funds can outperform their benchmark indexes, most of them historically have not, though of course some actively managed funds outperform from time to time, or even over the long term. Proponents of active funds say the benefits include greater flexibility, the ability to hedge, and the ability to better manage taxes by having more control over when securities are sold. Active funds have greater flexibility because their managers are not limited by following the index; they can buy and sell whatever securities they think fit the fund's strategy. Fund managers can also hedge their bets by using short positions, futures, or options, whereas a passive fund typically can't. This added flexibility can lead to more risk, as investment decisions are in the hands of human managers who face fewer restrictions. 

The Morningstar Active/Passive Barometer is a semiannual report that measures the performance of U.S. active funds against passive peers in their respective Morningstar categories. The report showed that active funds outperformed passive funds in several categories during 2017, but the June report said this trend changed: "Just 36% of active managers categorized in one of the nine segments of the U.S. Morningstar Style Box both survived and outperformed their average passive peer over the 12 months through June 2018. In 2017, 43% of active managers achieved this feat."

The report makes it clear that actively managed funds "have left much to be desired" over the longer term.

There may be room for both active and passive funds in your portfolio

Sometimes passive funds do better than active funds and vice versa. Most of the arguments for and against either are generalities; there are no absolutes.

Actively managed funds can be costlier if trades are made more often, and frequent trading can also have tax implications. High turnover may also be a consideration for passively managed funds, however: If the index has a lot of turnover, the fund will as well.

Actively managed funds may be best for investors who want to make specific bets on the market or who believe in specific managers. Actively managed funds can offer investors a chance to outperform the overall market. Passively managed funds may be best for investors who want to "set it and forget it," as they can provide consistent low-cost market exposure. But again, these guidelines aren't absolute. 

Active and passive funds are very different beasts, but there may be a place for both in an investor's portfolio.