Understanding active and passive funds
Learn more about differences between these two investment types.
If you’re interested in investing in mutual funds or exchange-traded funds (ETFs) – or you already have some in your portfolio – you may be wondering what exactly the difference is between an active and a passive fund.
The subjects
An active fund comprises stocks and bonds that have been selected by a portfolio manager for the fund, while a passive fund tracks an index, like the S&P 500. The passive fund often uses a representative sampling method to “match” the characteristics of the index in the fund, and its intention is to reflect overall market performance. Generally, active funds try to beat the market while passive funds reflect the market.
The testimony
Here’s a summary of how the two approaches differ.
|
Active funds |
Passive funds |
|
Attempts to outperform the market |
Does not beat the market because it tracks the market |
|
Possibility of underperforming against the benchmark |
There are no strategies in place to limit losses when the market is down |
|
Portfolio managers have the flexibility to invest in special assets, which may offer distinct investment opportunities |
Fund is transparent because you always know exactly what it’s invested in |
|
Higher fees, because there’s more work involved in the management of the fund |
Lower fees, which on average can be less than half that of a managed fund |
|
Could have more taxable capital gains because the portfolio manager may trade more often |
Usually has fewer taxable gains because there’s less trading involved |
The takeaways
Both active and passive funds have their benefits, and much of the decision to go with one or the other will be based on the investor in question. Your advisor can help factor in your risk tolerance and time horizon to determine how either – or both – may be an appropriate fit for your portfolio.
Before you make any mutual fund or ETF investments:
- Research the historical returns and expense ratios
- Determine your risk tolerance and timeline for the investment
- Speak to your advisor about your current situation and financial goals
The S&P 500 is an unmanaged index of 500 widely held stocks. An investment cannot be made directly in this index.
Sources:investor.vanguard.com; experian.com; investopedia.com; nerdwallet.com; investor.vanguard.com; thebalancemoney.com