Active and passive investing represent opposite approaches to money management. Active management involves the selection of individual financial securities and the trading of these shares in response to the markets. Passive mutual funds and exchange-traded funds do not trade securities as often as active ones. Instead, passive fund managers design their products to resemble a broader market index. In the 10-year period leading up to 2012, investors withdrew $543 billion from actively managed funds while investing $660 billion into passively managed funds, according to the ETF Trends website.
Active fund managers invest with a goal to deliver profits that are higher than some industry barometer to which the fund is designed to beat. An example of one such index is the S&P 500, which represents trading in some of the largest U.S. stocks. Active fund managers rely heavily on research to determine when to buy or sell securities in a fund. Passive managers are doing their jobs if an investment portfolio performs as well as the index it tracks. Less trading activity occurs in passive funds compared with active portfolios.
Active managers charge investors about 1.3 percent of assets each year, according to an article on the Knowledge@Wharton website. These expenses exceed those charged by passive fund managers -- fees that can be less than 0.2 percent each year -- given active fund managers' mandate to perform better than average. Passive managers often use price as a feature on which to compete, given that their investment products are often similar. Companies that oversee exchange-traded funds have been known to compete fiercely on price, according to a 2012 article in "The Wall Street Journal."
Active managers focus on the current and potential financial performance of individual companies when building a portfolio. In doing so, they expose investors to the risk of human error. However, passive managers do not believe in taking chances that may not pay off. They avoid this risk by investing in entire investment categories or sectors, according to a 2011 article on the CBS MoneyWatch website. The active management style endorses the belief that the stock market has inefficiencies that human beings can identify and profit from, while passive managers disagree. However, passive funds are also less nimble than active ones and are not usually in the business of rearranging securities in a portfolio when performance is suffering.
The success of active and passive management is affected by the nature of the securities in a fund. In a study by Dow Jones S&P Indices cited on the MarketWatch website, less than 33 percent of active managers of U.S. stock funds were able to outperform the S&P 1500 index between 2007 and June 2012. The expertise of active managers may become especially valuable when identifying opportunities in smaller stocks, where performance is more difficult to predict than with better-known large companies.
By Zacks Investment Research