Actively vs. Passively Managed Funds: What’s the Difference?

What Are Actively Managed Funds?

Actively managed mutual funds or exchange-traded funds (ETFs) are funds where the portfolio manager takes a hands-on approach to investing your money.

The goal of an actively managed fund is to beat the market, which means that the fund manager is regularly making trades and employing various strategies to take advantage of short-term price fluctuations.

Pros

• Potential to beat the market: In some cases, actively managed funds can perform better than passively managed funds, giving you the potential for higher returns.
• Flexibility: Active fund managers don't have the same limitations on what they can invest in as passive fund managers, so there may be opportunities to take advantage of special opportunities that come up.
• Other strategies to limit losses: Active fund managers employ various strategies to hedge against losses and manage your taxes as efficiently as possible.

Cons

• Most don't beat the market: As one example, Goldman Sachs has found that only 32% of large-cap core mutual funds have historically outperformed the S&P 500.
• Higher fees: Whether or not your fund beats the market, actively managed portfolios typically demand higher fees because there's more work involved. The average annual expense ratio for an actively managed fund is 1.4%, according to a report by the Goizueta Business School at Emory University. In contrast, the average passive fund charges 0.6%.
• Less tax efficient: Because active fund managers are constantly buying and selling securities, you'll end up with short-term capital gains most of the time, which are taxed at a higher rate than long-term capital gains—to get this lower rate, you need to hold an investment for at least a year.

What Are Passively Managed Funds?

Passively managed mutual funds and ETFs utilize a buy-and-hold strategy by tracking a specific market index, such as the S&P 500.

The goal of a passive fund is to match the market (before fees are taken into account). Additionally, there are almost always minor variations between the fund and the index, as it's difficult to track an index perfectly.

Passively managed funds are typically best for investors with a long-term investment horizon.

Pros

• Transparency: When you buy a passive fund that tracks a market index, you know exactly what the fund is invested in at all times.
• Lower fees: As previously mentioned, the average passive fund charges an expense ratio of 0.6%, which is less than half of what active funds charge. Some funds charge less than 0.05%.
• Better tax efficiency: While you won't get the same tax management strategies as an actively managed fund, you generally don't need to, as passive funds don't trade often.

Cons

• You'll almost never beat the market: While it's possible to beat the market with some active funds, it'll virtually never happen with a passive strategy. While the fund itself may be able to match the benchmark return, you'll end up with a little less after fees.
• Less flexibility: Because a passive fund tracks a specific index, it'll never take advantage of other short-term opportunities outside of that index. And if the index goes down, there are no strategies in place to limit your losses.

Actively vs. Passively Managed Funds Example

To give you an idea of how these funds work, here are a couple of examples.

Passively Managed Fund

Let's say that you invest in a passively managed ETF that tracks the S&P 500. For its work, the ETF charges you a 0.2% annual fee. Because the fund invests in the stocks that make up the S&P 500, you'll always have a good idea of how it's performing by looking up the price for that index.

When all is said and done, the annual fee and minor variations between your fund and the index won't make too much of a difference, but expect your return to be a bit lower than the S&P 500's return every year. The fund manager may make some trades as the makeup of the S&P 500 changes, but they'll be few and far between.

Actively Managed Fund

In contrast, let's say you decide to invest in an actively managed equity ETF, which invests solely in large-cap stocks like the ones included in the S&P 500. While your fund may include many of the same stocks that are in the S&P 500, your portfolio manager will also look at other stocks and adjust the fund's holdings to take advantage of price changes for individual stocks.

The portfolio manager will use a variety of strategies to try to give you a better return than what you could get with a passive fund tracking the index, but there's no guarantee. Even if you do, you'll need to pay a higher annual fee for the service, and you can expect higher taxes due to the frequent trades.

How to Decide Between Actively and Passively Managed Funds

As you try to determine where to invest your money, it's important to do your research and compare the benefits and drawbacks of each of your options.

In addition to considering the general pros and cons of active and passive funds, you'll also want to look at individual mutual funds and ETFs to make your decision. Compare their historical performance and fees to get an idea of which one might offer you the better return.

You'll also want to consider your risk tolerance and time horizon. Actively managed funds hope to capitalize on short-term wins but carry more risk for that potential reward. In contrast, passive funds typically carry less risk and are better suited for someone with a long-term strategy.

Remember, though, that within each category, risk and reward can vary wildly depending on the focus of the fund.

If you're having trouble determining the right approach to investment, consider consulting with a financial advisor who can help you achieve your goals.