If you follow investing, you may know the active vs. passive investing debate has been going on for a while.
Ever since Jack Bogle, founder of Vanguard, created index funds—the first passive investing option—experts have been arguing for and against the strategy.
With experts plugging the merits of both sides, it can be confusing to navigate—especially without a clear winner.
So, which one is better? Well, it depends.
By understanding the basics, it may be easier to craft your own investing strategy. That way, you’ll be able to weigh in for yourself next time someone brings up the active investing vs. passive investing debate.
What is Passive Investing?
Have you ever watched the news after a volatile day in the stock market? Reporters may talk about the S&P 500 or Nasdaq being down.
Each is a key representative of the stock market (an “index”), composed of a weighted basket of securities. They serve as benchmarks for the U.S. stock market’s performance.
Passive investments, like index funds or ETFs, try to mirror a stock market index.
To do this, the fund manager buys all, or a good sample, of stocks or bonds from the index, and holds onto them. The goal is to match how the index performs over time. Your returns will be comparable to that part of the market.
Passive investing continues to grow for several reasons:
- Low cost – Index funds and ETFs are generally less expensive. Because there is less management, expense ratios are lower. Knowing what you pay in fees is important because it can add up to a lot more than you think.
- Transparent – Passive investing is simple and easy to understand. If you are curious about the underlying investments, you can see holdings in both active and passive funds.
- Tax efficient – Depending on your type of account, selling investments may trigger a bigger tax bill. But passive investing generally involves less selling, so it may not be as much of a concern.
These are strong selling points, but there are shortfalls, too.
There is no opportunity to outperform the stock market. And when the stock market takes a nosedive, it may be harder to cut back on losses.
What is Active Investing?
Active investing is exactly the opposite approach.
Fund managers are more involved. They do a lot more buying and selling within the fund to try and beat their specific benchmark. Some of the benefits of active management may include:
- May outperform the index – With the expertise and hands-on strategy of an experienced fund manager, it may be possible to earn better returns than the market. But most managers have struggled to outperform their benchmarks on a regular basis.
- Possible to reduce losses – No one can predict what will happen in the stock market. While there is plenty of upside potential, there will be down years, too. In these scenarios, active managers may have the ability to reduce losses.
Often, the biggest critique of active management is the cost.
It’s a lot more expensive without the guarantee of better performance. Funds may also fluctuate when an analyst or manager changes firms.
How Do You Decide Between Active Investing vs. Passive Investing?
You may be eager to decide on whether active or passive investing is better.
But unfortunately, like many areas of personal finance, there is no clear-cut answer. And it may change depending on your age, goals, net worth, and timeline.
When you are less experienced, you may prefer the simplicity of passive investing.
With less to invest, low fees and transparency may be a good fit. Our passive investing strategy at Twine includes low-cost ETFs for this reason.
But sometimes, active management is a better choice. When your situation is more complex, or you have a higher net worth, you may need custom options. It’s possible you are willing to take bigger risks for bigger potential returns. Or, you may want professional guidance during the next market downturn.
So…active vs. passive investing?
Your choice doesn’t have to be mutually exclusive. Because every asset class is different, you may like a buffet-style portfolio with a mix of passive and active investments.
Studies show where active managers are likely to add value—and when it’s difficult to justify the fees.
If the decision feels too overwhelming, don’t be afraid to talk with an investment professional.