In the world of investing, you’ll often hear about passive and active investment management. So what’s the difference?

Passive management aims to mimic the returns of a broad stock market index like the S&P 500, which tracks some of the largest companies in the United States. In other words, the goal here is to capture the returns of the overall stock market.

Active management’s mission is to outperform or beat a stock market index. So if you’re deciding between an actively managed or passively managed fund, it can seem like a no-brainer. Why not go with the one that wants to beat the market?

Research shows that actively managed funds rarely outperform their benchmarks, especially when higher fees are taken into consideration.

However, this doesn’t mean it never happens. It doesn’t mean you can’t find hidden gems or instances when an actively managed fund is likely to outperform.

So let’s take a closer look.

Active Versus Passive Management

When it comes to actively managed funds, the fund managers take on a highly hands-on approach. They are constantly making decisions about whether to buy, sell, or hold. They make these decisions based on a high level of research and market analysis. This is one of the reasons why fees tend to be on the higher end for active funds. Basically, these people are doing a lot of work, and so their fee structure reflects that.

Actively managed funds also involve frequent buying and selling or turnover, which results in higher commission costs.

Passively managed funds are more focused on a buy-and-hold strategy. This reduces turnover and is one way they can offer lower fees. In fact, some can be as low as 0.06 percent.

But higher fees are justified when the active fund manager can significantly beat their respective index rather than just mirroring it.

This tends to happen when it comes to less efficient markets in which there is not much information available. Here, an experienced fund manager may be able to find hidden gems among undervalued stocks or emerging markets.

Active managers may also outperform their passive counterparts during market declines or crashes. Here, skilled managers can sweep into defensive sectors or use their know-how to find opportunities. A passively managed fund can’t do this.

If the fund is trying to reflect the market, then it’ll have to reflect the crash, too.

Which Is Best?

Choosing between an actively managed or passively managed fund ultimately comes down to personal factors like your investment goals, risk tolerance, and time horizon.

Long-term investors tend to go the passive route. And, theoretically, this should have helped them meet their goals. Historically, bull markets have lasted longer than bear markets. This is partially because stock prices tend to trend upward over time.

The passive investor is typically investing in the long term for goals like retirement. And they tend to believe that it’s impossible to beat the market consistently over time. So a passive strategy makes sense here.

But those who truly believe that with greater risk comes greater reward, the active path may seem more appealing. But to succeed with active funds, you’d need to do your due diligence and carefully examine the fund managers and other factors. Make sure the fund’s strategy aligns with your goals. And be clear that you can stomach the fees and risks.

But who says you can’t have both? After all, diversification is key to investing. So why not build a portfolio with both active and passively managed funds? Some investors use what is called a core-satellite strategy. This involves dedicating the bulk of your portfolio to passively managed index funds and a smaller portion to actively managed funds in order to benefit from potentially higher returns, while mitigating risk.

But there’s also a middle ground.

What About Smart Beta?

Smart beta is a strategy that combines elements of both active and passive management.

Like passive funds, smart beta funds focus on indexes. Many passively managed index funds base their holdings on market capitalization. But smart-beta funds look to other elements that could help balance risk and return. These can include value, quality, momentum, and low volatility.

These often appeal to investors who want to mitigate specific risks. For example, risk-averse investors may turn to low-volatility funds.

The Bottom Line

Active management seeks to outperform stock market benchmarks. However, this rarely happens. This makes it difficult for some investors to justify their fees. But this doesn’t mean you should ignore active strategies completely. Some fund managers have been able to find hidden gems. And active funds can hold a defensive position during market downturns that passive funds can’t. Still, you don’t need to choose from one or the other. Passively and actively managed funds, as well as smart beta strategies, can all hold a place in a well-diversified portfolio.

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