Passive vs. Active Investing: Compare and Contrast

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It’s always best to provide definitions before we make our comparisons.

Passive Investing

Definition

Passive investing focuses on buying and holding assets long term. Invest, then leave it alone, for you want the investment to grow through the ups and downs all the way to retirement.

The prime example of the passive approach is buying a fund that follows an index such as the S&P 500. The first passive index fund was Vanguard’s 500 Index Fund, launched by index fund pioneer John Bogle in 1976. The funds automatically adjust holdings by selling any stock that’s leaving the index and then buying the stock that’s coming into the index. According to industry research, around 38 percent of the U.S. stock market is passively invested.

How It Works

The “set it and- forget it” approach is intended to match overall market performance. Fewer transactions with this strategy will mean lower transaction fees that can eat into your cumulative overall financial growth. Besides, passively managed funds impose lower expense ratios than active funds since there is little research and maintenance involved. The average expense ratio for passive mutual funds is 0.06 percent, and for passive exchange-traded funds (ETFs) only 0.18 percent.

Compare that, for example, to the popular Cathie Wood ARK ETF (Disruptive Innovators), with management fees of 0.75 percent. Active investing management fees are higher because active buying and selling triggers transaction costs, and you’re paying the salaries of the financial team researching which stocks to buy.

Since passive strategies are “fund-focused,” you’re investing in thousands of stocks and bonds. This provides diversification and decreases the chance that one investment that tanks can be much of an overall impact to your portfolio. With passive investing the index tracked by your fund is constrained to its objective.

That transparency is a plus because actively managed funds don’t always follow a particular strategy; the manager may have his or her own ideas where to invest and how to invest. The active managers are competing with both passive index funds and their fellow active investing managers, so they will use their judgment.

Warren Buffett Bets

Because passive funds invest long term, they almost always result in higher returns. Over a 20-year period, for example, 90 percent of index funds tracking companies of all shapes and sizes outperformed their active counterparts. Research from S&P Global found that over a 20-year period only about 4.1 percent of professionally managed portfolios in the United States consistently outperformed their benchmarks. In three-year spans of time, more than half did as well, according to the S&P Indices Versus Active (SPIVA) report from S&P Dow Jones Indices. Thus, Warren Buffett made his bet.

In 2008, Warren Buffett made a million-dollar bet that a simple S&P 500 Index fund would outperform a basket of at least five hedge funds over a period of one decade. The bet concluded at the end of 2017, and Mr. Buffett’s S&P 500 Index fund enjoyed a 7.1 percent annual gain, securing his victory.

Sometimes, highly paid experts are just wrong. Warren Buffett proved that point by winning his 10-year wager with hedge fund manager Ted Seides of Protégé Partners.

Mr. Buffett bet the investment industry that a Vanguard index fund that invested in the S&P 500 would outperform any hedge fund over 10 years. Mr. Seides accepted the bet and put up a group of five hedge funds against the index fund. The hedge funds averaged 2.2 percent returns compared with the more than 7 percent for the index fund. And the $1 million prize? Mr. Buffett donated it to charity.

Tortoise Rather Than the Hare

While passive investing isn’t flashy, it clearly has the long-term investing advantage over active investing. If you’re looking for excitement, particularly short-term, you are likely to be drawn to active investing. The recent skyrocketing returns of the AI stocks such as Nvidia, along with Tesla, Microsoft, Alphabet, and Apple have drawn many enthusiastic investors.

Modifying your passive investment long-term investing strategy to include some portion of active investing is probably not a bad idea. You don’t have an exit strategy in a bear market.

Historically, the market always recovers, but you don’t know how long that might take. This is why you periodically revise and rebalance your asset allocation over time (see our previous article about Balancing and Rebalancing your Portfolio). As you get closer to retirement your portfolio will need to become less risky, more conservative.

Figure 1. CNBC inquiry to develop ARKK stock chart across 5 years’ time. (www.cnbc.com)

Active Investing

Definition

You may conclude that passive investing is the path you want to take, especially since the costs are lower than the active investing products. Active investing can involve frequent trading with a goal of beating average index returns.

It can be exciting to trade actively, and you can do it with your smartphone using apps like Robinhood. “This type of investing typically requires a high level of market analysis and expertise in order to determine the best time to buy or sell investments,” says Kevin Dugan, investment advisor and senior partner at Dugan Brown.

You can actively invest, or you can outsource it to professionals via actively managed mutual funds and active ETFs. The number of these funds is daunting so without a lot of education and experience you may be best off hiring a professional. The sheer volume of quantitative and qualitative data about securities, markets, and economic trends is overwhelming to most, few can find the time and resources to dive deeply into it.

Familiarity with fundamental analysis, such as analyzing company financial statements, is essential. It also requires constant attention, as the investing landscape is dynamic and volatile, requiring vigilance.

Short-term investing strategies can include active investing. If an investor chooses to allocate a portion of his or her investment portfolio to active investing, leaving the lion’s share in passive index funds, the gains have the potential to jump much higher than the passive returns. This is a function of one’s tolerance for risk, and what portion they then allocate to speculation is a function of their individual risk profile.

Tax-Efficiency

Active investing can also include a strategy to make loss trades that offset gains for tax purposes, a subject we covered earlier in an article called “Tax-Efficient Investing.”

“Tax-loss harvesting” involves both active investing trades along with the passive investing portion of your portfolio. Clients who have large cash positions may want to actively look for opportunities to invest in ETFs just after the market has pulled back.

Higher Risks

Whether meme stocks or pandemic-type fads and trends, active investing can burn the average investor. Peloton, for example, traded at $145 on Jan. 4, 2021. Just one and a half years later, that stock traded for less than $10 as pandemic plays in general fell out of favor. Cathie Wood’s ARK ETF (Disruptive Innovators) lost more than half the pandemic market price, even though it was a very popular investment during 2020.

Passive and Active Investing: Summary

• Active investing is hands-on and often best left to a professional financial advisor.
• Passive investing involves fewer transactions and less direct involvement, as indexed or mutual funds can run on autopilot.
• Both investing styles can be successful, but for the reasons we highlighted in this article, passive investments have attracted far more investments than active investments.
• Passive investments have earned more money than active investments.

Active investing has recently become more popular as speculation in memes and tech stock have attracted retail investors, hedge funds and other financial institutions.

(Courtesy of Rodd Mann / Summary of the main differences between passive and active investing)

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