Investing > Active vs. Passive Investing

Active vs. Passive Investing

Does active investing still have a place in a world where the passive approach seems to be winning the throne?

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Updated April 29, 2022

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Does it pay to be industrious? 🏭

The obvious answer appears to be yes. This is true both for everyday life, and the stock market—especially with all the movies filled to the brim with nail-biting scenes of hot-shot brokers making precipitous yet lucrative decisions at a moment’s notice. 🐺🏛

However, as is often the case, the reality isn’t quite so simple.

An active approach can indeed net you hefty returns, but these often come with increased risks and fees. The merits of passive investing appear so many, that even the investment legend Warren Buffett showed his favor towards it very decisively. Still, there are many who are standing by active investing.

A relatively high-profile example of this comes in the form of Ted Seides, a New York-based hedge manager who once bet $1 million against index funds—and Buffet—and lost, and still firmly believes that his choice was correct.

And he is far from alone in taking this—the stock market is a complex game and dismissing half of it would be foolish, especially since there are some scenarios where active investing obviously beats its more hands-off counterpart.

So, let’s delve right in, and examine all the pros and cons of active and passive investing—and how to use them both to your advantage.

What you’ll learn
  • Active vs. Passive Investing
  • The Types of Active Investing
  • The Types of Passive Investing
  • Active vs. Passive Funds
  • Advantages and Limitations of Active Investing
  • Advantages and Limitations of Passive Investing
  • Combining Active and Passive Investing
  • Which Approach is Better for You?
  • Conclusion
  • Choose a Reliable Stock Broker

The Difference Between Active and Passive Investing ⚔️

In a nutshell, passive investing simply tries to match the performance of the market, while active investing tries to beat it.

Passive investing tends to come in the form of various index funds that track a certain index—S&P 500 being one of the biggest and most popular ones—and attempt to match its performance by mimicking its composition.

However, it can be argued that any plan that involves holding a long position—perhaps by investing in bonds, or blue-chip stocks—can also be considered passive investing.

Active investing involves vigilantly following the market in order to react to any and all movements that could be to your benefit. Active investing generally comes in two main flavors—either you directly trading individual stocks, or going for an actively managed fund.

Passive investing is similar in this regard, as, while it is most often associated with investment vehicles like ETFs, you could argue that any form of investing whereby you go for a long position is also a passive approach.

The Types of Active Investing 🏛️

As we’ve established, active investing comes in two main variants. The first could be considered the more laid-back option—this is when you choose to invest in an actively managed hedge or mutual fund.

Leaving it to the Professionals ⚖️

Here, you aren’t doing the heavy lifting, the fund manager is. This style of investing can give absolutely stellar returns as is showcased by Cathie Wood’s ARKK ETF and its returns for 2020 which totaled at just above 150%.

ARKK ETF
Like many tech stocks and indices, ARKK vastly outperformed the S&P 500 between 2017 and 2021. Image by TradingView.

On the other hand, even this juggernaut can be used to showcase the weaknesses of active funds. Michael Burry has attempted to short it in May 2021 in the wake of skepticism roused by waning returns.

This follows the general trend of active funds underperforming compared to their passive counterparts with those that are beating the market while being few and far in between.

Still, many experts urge investors not to forsake these investment vehicles as they can be both highly lucrative—despite their shortcomings—and are a crucial component of a healthy, dynamic stock market.

If You Want Something Done Right… 📈

The other option at your disposal is to take matters into your hands. This would involve keeping a wakeful eye on your portfolio to react timely to any advantageous or disadvantageous movements that prices make.

Whenever you are holding a short position or engaging in day trading you are taking an active part in the stock market. The advantages of this approach are similar to those of active funds.

Essentially, by being as proactive as you can you can score some excellent returns when you, for example, catch a trend before the indexes. Additionally, while diversification is generally considered a key component of a good portfolio, by focusing some of your assets on a narrower field you can avoid the dampening effect funds have.

Of course, even though the wide nets that funds cast will limit your losses in case some of the companies that are invested in get obliterated, they also stagger your gains.

Another major advantage of active investing is that it allows you to preempt sudden downturns by timing your sales and purchases right. The downside of this is, of course, that none of us is omniscient, and very expensive mistakes can be made.

Another problem of active investing is that due to its dynamic nature it can often trigger both more plentiful and unfavorable short-term stock-related taxes even if you play all your cards right. On the other hand, the agility this approach gives you means that you can get creative, perhaps employing methods like tax-loss harvesting to turn some losses into gains.

The Good and the Bad with Active Investing

Pros

  • Potential for great returns
  • Proactivity and human oversight
  • Ability to timely hedge against losses

Cons

  • Higher risks
  • Less reliable returns
  • Incurs more taxes and fees

The Types of Passive Investing 📉

While often considered practically synonymous with index funds, passive investing can also diverge into two main branches. Anytime you employ something akin to a fire and forget approach, you are essentially committing passive investing.

A Direct Approach 💰

As we’ve already stated, these can include long positions using well-established stocks, or hedges involving gold, or bonds—the latter perhaps in an attempt to establish a decent dividend income.

While you would usually do this through a broker, direct stock purchases are another way of getting into passive investing. While in a world of low and no-cost online brokers, this method is mostly obsolete, it can still net hefty profits if you pick the right companies to invest in.

🏆 FYI: The easiest and cheapest way to get exposure to the wider stock market is by using one of the top online brokerages in the country.

Passing the Torch 🔥

The other way of passive investing is putting your money into passively managed mutual funds and ETFs. This is generally a good option as the stock market has historically been giving good returns and has kept consistently growing ever since its inception.

Hedge funds can also be considered a form of passive investing however they merit a special disclaimer—they tend to be a subpar choice. Much like other actively managed funds, they seldom outperform the market and its indices. 

Additionally, they also employ a so-called 2 and 20 fee system. Without going to much detail, the hedge funds take both a flat fee of between 1 and 5% of the money you have invested—though this number is usually around 2%. Furthermore, most of these funds take 20% of any returns made within a year before spreading the rest among their investors. This makes only a few best-performing hedge funds even worth considering.

Whichever option you choose, be mindful that not all indices—and thus not all passive funds—are quite the same. Some are more volatile than others meaning that if you go for one that follows the S&P 500, you can generally confidently count on regular yearly returns of about 10%, but if you pick a more specialty fund you could see gains in the hundreds of percents, or—in some cases—steep losses.

Leaving it to the Robots 🤖

Another way you could go about passive investing is by setting yourself up with a robo-advisor. Robo-advisors are automated services that try and match their clients’ needs utilizing algorithms to build a portfolio as optimal as possible. They tend to be the cheapest option you can possibly find.

This is due to the fact that while humans are making the overarching strategies, trades are made by the AI—while you would need to pay living traders, robots don’t need wages.

While a lack of extensive human oversight is a bit of a staple of passive investing—and good robo-advisors tend to match the performance of large indices—they are ultimately powerless to save you from large price collapses on the stock market. 

The only way to escape this inconvenience is to go for a super conservative portfolio allocation that will always net poor returns. On the other hand, crashes are something that human-managed passive funds can in some cases at least mitigate.

The Good and the Bad with Passive Investing

Pros

  • Simpler than active investing
  • Usually cheaper than active investing
  • Often reliable

Cons

  • Performs only as well as the market
  • Less potential for immense returns
  • Offers little defense against massive price changes

Active vs. Passive Funds 💸

Trying to beat the market as opposed to trying to match it isn’t the only difference between active and passive funds. It just might not be the most important one either. 

Briefly, as index funds match indices they tend to be more reliable, at the cost of lower likely returns. Active funds offer excellent opportunities for gains, but at an increased risk as more decisions are being made in an attempt to predict the movement of prices.

Just like the world tends to operate on two principles—higher risk=higher reward, and more work=more pay—so does investing. So let’s take a look at a couple of examples of active and passive funds—we’ll be comparing ETFs to ETFs and mutual funds to mutual funds so as not to mix apples and oranges.

On the side of actively managed ETFs stands Ark Innovation ETF (ARKK), with an impressive 5-year return of 48.65% and an expense ratio of 0.75%. For the passive ETFs, we are looking at Vanguard’s Value Fund Admiral Shares ETF (VVIAX) with a 5-year return of 13.41% and an expense ratio of 0.05%.

When it comes to mutual funds we’ll look at the Schwab S&P 500 Index Fund (SWPPX) and the active Fidelity Contrafund Fund (FCNTX). SWPPX boasts an expense ratio of 0.02% and a 5-year average of 17.12%—and FCNTX has an expense ratio of 0.86% and a return rate for the same period of 19.52%.

Let’s Summarize 📝

Did you catch that? OK, here’s the gist of it: All these funds have an expense ratio of less than 1%, which might appear completely insignificant, but small numbers have a quaint tendency of becoming gargantuan over longer periods. So, let’s look at what you’d be getting after ten years of investing in funds of a similar performance, and similar expense to the ETFs.

DescriptionActive FundPassive Fund
Initial investment ($)50005000
Yearly investments ($)10001000
Number of years1010
Average yearly return (%)4513
Expense ratio (%)0.750.05
End value with fees subtracted ($)318,945.1537,652.57
Cost of fees ($)15,640.09134.58

These numbers truly showcase both how much more money can a good active fund net you—and how much money you’d lose on higher fees. We should remember though that the numbers for the active fund have been based on ARKK’s 5-year performance—and that fund has been a bit of an exception over the years.

For ease of comparison, if we were to bring down the active fund’s yearly returns to the same 13% —you’d end up with $35.817,50 after subtracting $1,969.65 in fees.

Advantages and Limitations of Active Investing ⚖️

In summary, active investing, when done right, can bring you stellar returns if you pick the right stocks at the right time. Additionally, the more hands-on approach of active investing can really help keep you ahead of the trade winds and bolster your ability to come out on top even in an unfavorable market.

Just look at how Michael Burry profited amidst the 2008 financial crisis utilizing short selling—a practice that definitely falls under active investing. Or, how George Soros utilized a similar technique to profit both from the British pound and the Thai baht.

Furthermore, Burry has attempted it twice in the span of just a few short months—not only against ARKK ETF but doubling down on his bet against Tesla in August 2021. This ability to nimbly react to any potential shifts on the stock market, as well as the rewards a good call can get you truly represent the strong points of active investing.

However, we shouldn’t forget that it is a high-risk, high-reward game. Yet again coming to shorting, the beginning of 2021 saw the fortunes of many active investors and short-sellers tumble with the GME and AMC debacles.

The big limitations of active investing stem from the inherent unpredictability of the market. It is impossible to predict everything and hedge correctly against every danger. Furthermore, the fact that unless you are a big financial institution or a full-time trader, you likely won’t be able to diversify your portfolio properly and protect yourself in that way at least.

And even if you go for actively managed funds—that do give you that layer of security—you often remain at the mercy of high fees, unwanted taxes, and lackluster performance.

Advantages and Limitations of Passive Investing 🏦

Passive investing on the other hand offers ease and reliability. Combined with overall lower costs—both in fees incurred and taxes paid—generally means that once you put your money in stocks, bonds, gold, or whichever long-term investment you pick, you can be reasonably certain you’ll get quite a bit more than what you’ve given once the time to withdraw comes.

Due to low costs, and a similar kind of relative reliability, the same applies to investing in passive funds. Furthermore, it is easier to achieve that all-important diversification through passive investing as you are either putting your money into an already diversified fund or spreading your investments over time making it easier to cast a wide net.

Additionally, as there are usually no huge and immediate chances to take when investing passively, the stifling of growth from single successful stocks that occurs in big, spread-out funds is less of a concern than with the active counterpart.

On the other hand, this kind of investing won’t get you out of a tight financial spot in the present the way a good move with active investing could—nor will it do you any favors in case of a bigger crisis—especially if you have cash out soon after it hits.

It is also worthwhile to note that some experts believe that index funds are very bad for the market, especially as they promote inertia with their hands-off approach to investing.

Combining Active and Passive Investing 💵

There is no rule stating you can’t delve both into active, and passive investing. In fact, people like CNBC’s Jim Cramer actively endorse such a hybrid approach. And it makes sense. Modern Portfolio Theory states that diversification is a key component of successful investing.

Just as this applies to various securities, so can it apply to different approaches.

Generally speaking, passive investing makes way more sense when you have a significant amount of money already, and not that many years until you retire, than when you can venture into relatively few assets, and have most of your career ahead of you.

Then again, a small long-term investment made early will balloon in a few decades. Still, being active with at least a part of your portfolio to try and double what little money you have early in your career can pay off massively.

But having a significant portion of your assets invested in safe, long-term securities can also help boost your risk tolerance, and boost your resilience to possible unfavorable short-term outcomes. Thus, the hybrid approach really makes sense for everyone other than older investors with a lot of loot in reserve—just don’t go all-in into risky active assets.

That is the basic logic. Investing a significant amount in stable blue-chip stocks could help you invest in potentially very lucrative, but also very volatile penny stocks without much real danger to your livelihood. In the same vein, a significant portion of your portfolio vested in a big passive fund could allow you to take the risk and put some money in a potential high earner like ARKK.

Which Approach is Better for You? 🤔

The exact approach that would work for you is something only you can decide on. It will heavily depend on your overarching goals and risk tolerance. Probably the safest option would still be starting with mostly active investments and switching a vast portion of your money into long-term securities and index funds as soon as you have saved up a bit.

Still, that is far from a failsafe. Some people have made a fortune by heavily investing in only one place—there is little doubt that those who put their savings into Apple a good old gold ten, or fifteen years ago, can afford to spend their time patting themselves on the back.

Or, if you want an even more dramatic story, there are people like Ted Weschler who caught PayPal early and turned a $70,000 investment into $264 million. If these sound like decisive arguments in favor of a long-term, passive approach, we shouldn’t forget that those who—as silly as it might sound—bought DogeCoin in early 2021—and had the sense for timing—had a seventy-fold return.

That kind of success would be an achievement of decisive, quick active investors.

Not to repeat ourselves, but it is impossible to make general statements about what would be best. It is something that every investor should decide upon weighing the risks and rewards. 

Just remember that as easy as the hot-shots make it look, one of the major comments of Warren Buffet in his 2021 Berkshire Hathaway meeting was that picking out winning stocks is far from easy.

Conclusion 🏁

With so many arguments for—and against—both stances, there is little wonder that the debate between active and passive investing is still as heated as ever. Furthermore, it being further muddied by some infighting in both camps in favor of, and against both individual stocks and funds might make it seem like there are no clear answers.

Still, we feel that the main takeaway here is that all these different voices make the job of any individual investor easier. The lively debate makes it so that there is always an abundance of information you can learn from before plotting out your financial future.

FAQs

  • What is Better, Active or Passive Investing?

    There is no clear answer as to whether active or passive investing is better. When active investment goes well, it can give returns far higher than passive investing. However, it is also fraught with more risks. For this reason, passive investing is considered more reliable if with a lesser potential for spectacular profitability.

  • Is Active Investing Worth it?

    The worth of active investing can generally truly be determined on a case-by-case basis. On one hand, it carries more risks, and few active funds manage to outperform the market—however, when it does succeed it tends to be far more lucrative than passive investing.

  • Is Passive Investing Safer?

    Under relatively stable market conditions, passive investing generally gives more reliable results. However, in the case of increased market volatility, or a large downward turn passive investing usually doesn’t have the agility to hedge against losses and tends to go down with the overall prices.

  • What Are the Key Forms of Passive Investing?

    The most common form of passive investing is investing in various index funds. However, any form of long-term investing, as well as investing utilizing a robo-advisor is generally considered passive.

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