Active vs. passive investing?
Key Takeaways. Active investing requires a hands-on approach, typically by a portfolio manager or other active participant. Passive investing involves less buying and selling, often resulting in investors buying indexed or other mutual funds.
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.
Because active investing is generally more expensive (you need to pay research analysts and portfolio managers, as well as additional costs due to more frequent trading), many active managers fail to beat the index after accounting for expenses—consequently, passive investing has often outperformed active because of ...
Active versus passive funds
Critics of passive investing say funds that simply track an index will always underperform the market when costs are taken into account. In contrast, active managers can potentially deliver market-beating returns by carefully choosing the stocks they hold.
The biggest difference between active investing and passive investing is that active investing involves a fund manager picking and choosing investments, whereas passive investing typically tracks an existing group of investments called an index.
Active funds generally have higher expense ratios due to the extensive research, analysis, and management activities performed by the fund manager. On the other hand, passive funds have lower expense ratios because the fund manager's role is limited, and the investment strategy is relatively straightforward.
- Requires high engagement. ...
- Demands higher risk tolerance. ...
- Tends not to beat benchmarks over time.
Here's what the firm found from 20 years of research: Active vs. Passive: The active success rate for equity was 76% overall with actively managed funds surpassing passive funds 73% of the time.
According to extensive research, a staggering 94% of active fund managers do not beat the market. It's an inconvenient truth that even financial titans like Warren Buffett's Berkshire have now underperformed the S&P 500 over a 20-year period.
The passive strategy holds that the stock market is so efficient that active managers will not consistently beat the market because they will not be able to consistently pick undervalued stocks.
Is passive investing distorting the market?
Critics of passive investing got fresh ammunition with a recent study that found the boom in exchange traded funds has warped the stock market by distorting prices and increasing volatility.
For those who have no reason to hop into anything risky, passive management provides about as much security as can be expected. Because passive investments tend to follow the market, which tends to experience steady growth over time, the chance you'll lose your invested assets is low in the long run.
But the relatively recent entry of passive investors into such markets distorts the demand signal that the price sends, because they're buying futures without reference to those kinds of traditional considerations. This can make it harder for the manufacturer to predict demand, potentially driving up costs.
Passive investment is less expensive, less complex, and often produces superior after-tax results over medium to long time horizons when compared to actively managed portfolios.
| Active funds | Passive funds | |
|---|---|---|
| Pros | Potential to capture mispricing opportunities and beat the market | Convenient and low-cost way of gaining exposure to certain assets/industries |
| Cons | Fees are typically higher and there is no guarantee of outperformance | No opportunity to outperform the market |
Flexibility. Active managers can buy stocks that may be undervalued and underappreciated in the general market. They can quickly divest themselves of underperforming stocks when the risks become too high. They can choose not to invest during certain periods and wait for good opportunities to buy.
Active investing involves fund managers making active decisions over what to invest in. Passive investors look to replicate a given index or market. Both strategies have their strengths and weaknesses.
More than half of active funds and ETFs, 57%, outperformed their passive counterparts in the year from July 1, 2022, through June 30, 2023, an improvement from the 43% that did so the previous year, according to a new report from Morningstar.
Active management has typically outperformed passive management during market corrections, because active managers have captured more upside as the market recovers.
- Subprime Mortgages. ...
- Annuities. ...
- Penny Stocks. ...
- High-Yield Bonds. ...
- Private Placements. ...
- Traditional Savings Accounts at Major Banks. ...
- The Investment Your Neighbor Just Doubled His Money On. ...
- The Lottery.
What is the risk of active investing?
Active risk arises from actively managed portfolios, such as those of mutual funds or hedge funds, as it seeks to beat its benchmark. Specifically, active risk is the difference between the managed portfolio's return less the benchmark return over some time period.
But unlike passively managed funds, active funds are more volatile to the ups and downs of the market. For that reason, active investing is not the recommended strategy for long-term investing goals. "It's important to note that research shows that people and fund managers do beat the market from time to time.
Rowe Price U.S. Equity Research fund (ticker: PRCOX) is in this exclusive club, having bested—along with a team of about 30 research analysts—the S&P 500 index for the past five years on an annualized basis. U.S. Equity Research is a Morningstar five-star gold-medal fund.
Although it is very difficult, the market can be beaten. Every year, some managers boast better numbers than the market indices. A small fraction even manages to do so over a longer period. Over the horizon of the last 20 years, less than 10% of U.S. actively managed funds have beaten the market.
According to Bank of America, only 38% of large-cap funds beat their benchmark last year as any aversion to the megacap tech stocks dragged down their performance. To be able to meet or beat the performance of the S&P 500, fund managers need big tech exposure.
