Active vs. passive investing

Two approaches to investing: trying to beat the market by selecting investments, or simply owning the whole market through low-cost index funds.

What it means

Active investing means a manager or individual picks investments, or times trades, to try to beat a benchmark index. Passive investing aims only to match a market’s return by holding everything in an index, usually through an index mutual fund or ETF. Many people combine the two.

Research over several decades has generally found that most actively managed funds trailed comparable index funds over long periods, largely because of higher fees and trading costs. Some active managers do outperform in a given stretch, but identifying them in advance has proven difficult and results often do not persist. Active funds may also produce more taxable distributions in taxable accounts because they tend to trade more.

Example

Suppose $100,000 grows at 6% a year before fees for 30 years. With a 1.00% annual fee it ends near $432,000; with a 0.05% fee it ends near $566,000, a gap of roughly $134,000 from costs alone.

How it’s used

Choosing funds for a 401(k), IRA or taxable account
Comparing fees and long-term track records between funds
Deciding how much time to spend researching investments

Strengths and weaknesses

Strengths

Passive: low costs, broad diversification and little upkeep
Active: a chance to outperform or to limit certain risks
Active: flexibility to follow specific strategies or values

Weaknesses

Passive: fully shares in market declines and cannot beat its index
Active: higher fees must be overcome just to break even
Active: most funds have historically lagged their benchmarks over long periods

Good to know

When comparing funds, look at returns after fees against an appropriate benchmark over 10 years or more.

Educational information only, not financial, tax or legal advice. Rules, limits and rates change; check the IRS, your lender or plan, or a qualified professional before acting.