Passive vs active investing: what is the difference?

What is active investing?

Active investing involves a 'hands-on' approach. It requires the investor to manage the investment proactively by acting as a portfolio manager. The primary aim of active investing is to beat the average returns of index investing by taking advantage of short-term fluctuations in share prices.

By nature, active investing involves significant expertise, deep analysis and the knowledge and psychological stability to know when to enter and exit any one particular stock, bond or alternative asset. Usually, a portfolio manager will oversee a team of market analysts who consider the totality of fundamental, technical and sentimental factors to make a decision.

This all means that active investing requires serious confidence in whoever is managing the portfolio and their ability to time buys and sells. Critically, it requires being right more often than being wrong – and this is harder than it sounds.

What is passive investing?

Passive investors are a different kettle of fish. If you use a passive investing strategy, you invest with a long timeframe in mind, often stretching into decades. Passive investors limit buying and selling to a minimum within their portfolios, with a buy-and-hold mentality through any short-term spikes or dips. While more cost-effective, this strategy does require a level head, as it involves resisting the often-strong temptation to react to market movements.

The standard model of passive investing is to buy an index fund that follows one of the major indices, such as the S&P 500 or FTSE 100. Whenever these indices change their constituents (usually at quarterly reviews), the index fund will automatically sell the stocks that exit the index and buy the stocks entering it.

For context, this explains why being promoted to a more important index is consequential, as it guarantees that the company's stock will become a core holding in hundreds of funds, providing a further boost to its share price.

When you own shares in dozens or even hundreds of companies, your returns are predicated on the wider upward trajectory of corporate profits over time. For perspective, the S&P 500 has seen an average annualised annual return of 11.88% from 1957 through to the end of 2021.¹

Active investing advantages and disadvantages

Advantages of active investing

• Flexibility: Active managers can use their freedom to buy shares they feel are oversold or undervalued
• Hedging: Managers of active portfolios can use techniques such as put options or short sales to hedge portfolios and can exit positions if losses start to mount up
• Tax planning: By selling investments that are losing money, it's possible to reduce the capital gains tax due on those that have been successful

Disadvantages of active investing

• Higher risk: Active managers have the freedom to buy any investment, which means bigger losses if things go wrong
• Comparatively expensive: The average actively managed equity fund expense ratio sits at 0.68% in the UK, compared to just 0.06% for passive funds. While this increased fee covers the cost of more trades and the salaries of the manager and associated analyst team, it reduces the power of compounding returns. The manager must not only beat the index but cover this premium, too

Passive investing advantages and disadvantages

Advantages of passive investing

• Exceptionally low fees: With nobody actively picking stocks and fewer overall trades, the cost of following an index fund can be as low as 0.06%
• Transparency: It's always clear which assets you hold, as your investment usually follows a public index
• Tax advantages: The 'buy and hold' mentality means that capital gains tax can be deferred, with some investors even waiting decades for a better political atmosphere

Disadvantages of passive investing

• Smaller returns: Passive fund investing will never beat the market, and it will certainly never see the returns delivered by some of the best active managers. Of course, active management also comes with higher risk, and the past performance of a fund is no guarantee of future success
• Limited investments: Passive funds are by nature limited to a specific index or predetermined basket of investments, leaving investors locked into those fixed holdings regardless of market movements

Which is better: active or passive investing?

First off, this is not investing advice. Everybody's personal financial situation is different, and it's worth noting that economic cycles and changing fiscal rules can alter the case for both active and passive investing over the years.

While most people think that a professional active fund manager would outperform most index funds, this is not always the case. Indeed, there are decades of passive vs active investing studies that show passive investing yielding better results than those achieved by professional managers.

According to S&P Global Intelligence, between 2012 and 2022, 75% of large-cap, 73% of mid-cap and 80% of small-cap UK active managers underperformed passive investors. And once factor exposure is considered, 95% of UK active funds underperform their benchmarks. This data is easy to corroborate using research from Vanguard, Lyxor and ESMA. ²

Indeed, Eugene Fama, Nobel Laureate and father of the Efficient Market Hypothesis; William Sharpe, one of the inventors of the Capital Asset Pricing Model; and Harry Markowitz, the creator of Modern Portfolio Theory all support passive investing.

Arguably, passive investing is easier psychologically, given the better likelihood of returns involved. It's also worth considering that the risk-adjusted return of active investments is often lower than it appears.

However, it's not easy to say that passive investing is objectively better. For example, some active investors better managed the volatility caused by the COVID-19 pandemic. Many of these investors benefited from the bull market of 2021, then exited in the bear market of 2022.

It's also worth noting that an active investor who underperforms a passive investor in nine out of ten years can still beat their performance if the tenth year brings exceptional returns.

How much of the market is passively indexed?

According to figures from the Investment Association (IA), total assets under management in the UK reached £9.4 trillion in 2020, for example. At this time, passive strategies accounted for 31% of the £9.4 trillion, a one percentage point increase since the previous year.

A short history of active vs passive management

In 1602, the Dutch East India Company was granted a monopoly on the Dutch spice trade and chose to issue shares on an exchange rather than in the then-traditional marketplace. Buying shares in the company was arguably the first form of passive investing, as it was the first multinational corporation with activities spanning a vast array of sectors and geographies.

Passive investing truly hit the trading consciousness in 1951 after John Bogle released a thesis entitled 'The Economic Role of the Investment Company'. Arguing that active fund managers were unable to beat the wider market and that some form of index fund investing was preferable, he later went on to found Vanguard in 1975. Simultaneously, Nobel Laureate economist Paul Samuelson argued for 'some large foundation set up an in-house portfolio that tracks the S&P 500 Index – if only for the purpose of setting up a naïve model against which their in-house gunslingers can measure their prowess'.

With many investors dissatisfied with the underperformance of expensive fund managers, Bogle launched the trailblazing Vanguard Group First Index Investment Trust in 1976 with just $11.3 million in AUM, which later became the Vanguard 500 Index Fund. That fund now has over $250 billion in AUM and remains one of the most popular passive investments in the world.

With passive investing continuing to grow in popularity, the various merits of the two approaches continue to be subject to fierce debate.

Passive v active investing summed up

• Passive investing and active investing are both measured against common benchmarks like the FTSE 100 – but active investors look to beat the benchmark, whereas passive investors simply wish to duplicate its performance
• Active investing involves significant expertise, deep analysis, and both the knowledge and psychological stability to know when to enter and exit any one particular stock, bond or alternative asset. Advantages include increased flexibility, hedging and tax-planning advantages
• Passive investors limit buying and selling to a minimum within their portfolios, keeping a buy-and-hold mentality through any short-term spikes or dips. Advantages include low fees, transparency and capital gains tax advantages
• Many investors choose a mixture of both strategies for optimal results based on their risk attitude

¹ S&P 500 Average Return
² Active vs passive performance - UK - Occam Investing