A major debate has divided the investment world for years: active vs. passive investing.
Active investments are funds run by investment managers who try to outperform an index over time, such as the S&P 500 or the Russell 2000. Passive investments are funds intended to match, not beat, the performance of an index.
While there are advantages and disadvantages to both strategies, investors are starting to shift dollars away from active mutual funds to passive mutual funds and passive exchange-traded funds (ETFs). Why? As a group, actively managed funds, after fees have been taken into account, tend to underperform their passive peers.
This change is relatively recent. According to a study by Statista, passively managed index funds only comprised 19% of the total assets managed by investment companies in the U.S. in 2010, but this share had ballooned to 48% by 2023. In 2023, passive U.S. equity funds reported net inflows of $244 billion, while active funds saw net outflows in the ballpark of $257 billion, according to Morningstar. Not only did active funds dump assets across all nine equity categories, but large-value funds experienced their worst year from an organic growth perspective since 2000.
Active vs. passive investing
Active versus passive investing
Here are the key differences between active and passive investment funds:
| Active funds |
1. Are intended to outperform a specific index, called a benchmark. 2. Have human portfolio managers and analysts. 3. Tend to have higher expenses, which can hamper performance. |
| Passive funds |
1. Are intended to match -- not beat -- the performance of a specific index. 2. Are generally automated, with some human oversight. 3. Tend to have much lower expenses than active funds. |
Active: Pros & cons
Pros and cons of active investing
Active funds are run by human portfolio managers. Some specialize in picking individual stocks they think will outperform the market. Others focus on investing in sectors or industries they think will do well. (Many managers do both.) Most active-fund portfolio managers are supported by teams of human analysts who conduct extensive research to help identify promising investment opportunities.
The idea behind actively managed funds is that they allow ordinary investors to hire professional stock pickers to manage their money. When things go well, actively managed funds can deliver performance that beats the market over time, even after their fees are paid.
But investors should keep in mind that there's no guarantee an active fund will be able to deliver index-beating performance, and many don't. Research shows that relatively few active funds are able to outperform the market, in part because of their higher fees. The problem: It's not enough to just beat the index -- the manager has to beat the fund's benchmark index by at least enough to pay the fund's expenses.
That turns out to be a big challenge in practice. In 2023, for instance, 60% of large-cap U.S. actively managed equity funds underperformed the S&P 500, according to a scorecard report from the S&P Dow Jones indexes. This was the 14th consecutive year that the S&P 500 outperformed the lion's share of actively managed U.S. large-cap funds.
When all goes well, active investing can deliver better performance over time. But when it doesn't, an active fund's performance can lag that of its benchmark index. Either way, you'll pay more for an active fund than for a passive fund.
Passive: Pros & cons
Pros and cons of passive investing
Passive funds, also known as passive index funds, are structured to replicate a given index in the composition of securities and are meant to match the performance of the index they track, no more and no less. That means they get all the upside when a particular index is rising. However, it also means they get all the downside when that index falls.
As the name implies, passive funds don't have human managers making decisions about buying and selling. With no managers to pay, passive funds generally have very low fees.
Fees for both active and passive funds have fallen over time, but active funds still cost more. The average expense ratio overall for equity mutual funds fell 2 basis points to 0.42% last year, according to a March 2024 Investment Company Institute report.
In a 2023 ICI report, the average expense ratio for actively managed equity mutual funds fell 2 basis points to 0.66%; the average expense ratio for index equity mutual funds fell 1 basis point to 0.05%.
While the difference between 0.66% and 0.05% might not seem like a lot, it can compound the cost of your investment by thousands of additional dollars if you buy and hold your investment through multiple decades.
What's the takeaway for investors?
For someone who doesn't have time to research active funds and doesn't have a financial advisor, passive funds may be a better choice. At least you won't lag the market, and you won't pay huge fees. For investors who are willing to be at least somewhat involved with their investments, passive funds are a low-cost way to get exposure to individual sectors or regions without having to put in the time to research active funds or individual stocks.
But it doesn't have to be an either/or choice. 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.
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Keep in mind, though, that not all active funds are equal. 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. These managers often continue to outperform throughout their careers.
As always, think about your own financial situation, your life stage, and your ability to tolerate risk before you invest your money.
