Active vs. Passive Investing: Understanding the Differences

What is active investing (and when should I use it)?

An active investing strategy seeks to outperform the average returns of a particular index or “benchmark,” while appropriately managing risk.

Active investment managers take a hands-on approach to managing your assets: building and maintaining a portfolio to meet particular growth targets, risk management needs, wealth preservation goals and other key financial objectives.

Active investing can be advantageous because it allows you to react more nimbly to changes in the broader economy, such as periods of prolonged volatility or the presence of equities with higher risk factors.

For this reason, actively invested funds tend to outperform their indexed equivalents in most neutral or bear markets, perform comparably to passive funds in neutral markets and may pull ahead in times of significant volatility, such as the 2008 financial crisis, dubbed “The Great Recession,” or the more recent response to the Federal Reserve’s interest rate hikes starting in March of 2022.

What are the advantages of active investing?

Active investing holds several advantages over passive investing, provided the economic circumstances align with the basic tenets of an active investment strategy:

• Flexibility in volatile market conditions—The most significant advantages of active management are increased agility in volatile market conditions and insight into the market’s movements through value-based research and deep industry expertise. This helps you not only react to disruptions in the broader market but also anticipate its movements and plan your strategies accordingly.
• Increased tax efficiencies—Through active management, your financial advisor can take steps to lower your overall tax burden through strategies such as tax-loss harvesting.
• Broader investment options—Access to a private wealth management team can provide you with opportunities for growth and wealth preservation that may not be available to passive investors, such as being able to invest in private equity, real estate, hedge funds or philanthropic organizations.
• Potential for greater returns—By definition, active investment is the strategy of trying to beat the overall market, meaning that this strategy seeks to provide greater returns in the long run by finding ways to outcompete the benchmarks.
• Ability to build around concentrations and legacy positions—For investors with a high concentration or legacy position in a particular organization or industry, active management can help correct exposure and reduce risk by giving you options to rebalance your investment portfolio while retaining your existing positions.
• Access to other financial resources—Choosing an active investment strategy often results in access to other financial resources and services offered by the financial institution, such as estate planning, escrow and trust services, private banking and commercial banking solutions.

What are the disadvantages of active investing?

When compared to passive investing, an active investment strategy carries certain risks and considerations that should not be ignored:

• Generally higher fees: Active management fees can run from anywhere between 0.2% and 2% of the assets under management (AUM) annually, as compared to the expense ratios seen in passive ETF investment options, which average between 0.1% and 1%.
• Potential for triggering taxable events: Active investing has the potential to incur greater taxes as portfolio assets are bought and sold more frequently. This could trigger capital gains taxes and otherwise add additional costs.
• Performance depends on the skill of the manager: A key factor of active management is that the performance of the investment portfolio is directly related to the skill of the fund’s manager, meaning that you should perform your due diligence before choosing an active manager to assess their investment approach and past performance.
• Greater commitment of time and resources: Whereas passive investing requires purchasing a set allocation of funds every month (a task that can be automated), active management will require meetings with your advisor and a generally greater commitment of time and resources.

Bottom line: Active can make sense when you need customization, have legacy concentrations or believe a manager has a clear, repeatable edge and you’re disciplined about costs and process.

What is passive investing (and when should I use it)?

Passive investing buys broad indexes via funds/ETFs to match market performance with low costs and high diversification.

Often, this strategy centers on buying shares of index funds, ETFs and other “bundled” assets to reduce your exposure to risk by diversifying it over hundreds if not thousands of individual components.

In doing so, you can effectively duplicate the average growth of firms in a particular index (such as the S&P 500, the NASDAQ Composite or the Dow Jones Industrial Average) by purchasing shares of funds that will do the hard lifting for you.

In bull markets, passive management will often keep the pace of, and even outperform, active strategies, benefiting from environments that include low volatility, high correlations and low inflation.

For this reason, passive investment management is a common strategy during periods of prolonged growth (such as the period between 2009 and 2020) for investors who want to avoid the expense ratios common in actively managed investments or for individuals with a “set it and forget it” mentality toward their investments.

What are the advantages of passive investing?

Passive investing has numerous advantages that make it an attractive option for investors who want to take a “hands-off” approach to managing their finances:

• Consistent and low-risk returns: Because of the extreme diversification in most passively traded funds, investors will usually see a consistent return on their investment with generally lower-risk active management.
• Lower costs: Passively invested funds seek to track the benchmarks as closely as possible, meaning they accordingly have less overhead than actively managed funds (sometimes even at 0.1% AUM or less per year).
• Passive tax efficiencies: Because passive investing is a “buy and hold” strategy, the lack of sales results in fewer taxable events and increased tax advantages when investing in tax-advantaged accounts such as a 401(k) or an IRA.
• Simplicity and transparency: Warren Buffet famously advocates for investing in “what you know,” and this strategy carries over into passive investing through easy-to-understand funds and clear transparency in where your money is going.

What are the disadvantages of passive investing?

Finally, passive investing carries a few risks related to its more conservative approach to investment:

• Lower potential returns: Passive funds are designed to track a market index as closely as possible, meaning, by design, they will generally not beat or outperform the market.
• Lack of control over your distribution: Passive investors have no control over the distribution of individual securities their fund invests in and can only control the relative distribution of different funds in their overall portfolio (such as choosing an allocation of 80% stock and 20% bond-based ETFs).
• Underperformance in volatile markets: A fundamental weakness of a passive investment strategy is that your portfolio’s performance will match any volatility in the broader market, leading to opportunity loss in capitalizing on broad swings or market downturns compared to an active strategy.

Bottom line: Passive investment strategies fit investors who value low costs, simplicity and broad market exposure, especially over long horizons.

A practical middle path: the core-satellite blend

Many investors combine both:

• Core (70–90%): Low-cost index funds/ETFs across U.S./international stocks and investment-grade bonds.
• Satellites (10–30%): Targeted active ideas e.g., factor tilts (quality, small-cap value), a manager with a strong, repeatable process or a sleeve designed to manage a legacy position’s risk/taxes.

This approach keeps fees and taxes in check while giving room for selective active bets or bespoke constraints.

How to choose an investment strategy: a quick decision framework

Ask yourself:

1. Time horizon: Longer horizons increase the value of low costs and broad diversification.
2. Fee sensitivity: What’s your all-in cost today (expense ratios + advisory fees + trading/tax drag)?
3. Tax situation: Taxable vs. tax-advantaged accounts; need for harvesting or gain deferral?
4. Concentrations/constraints: Single-stock exposure, liquidity needs, values screens.
5. Behavioral fit: Prefer set-and-forget? Or do you want an advisor actively steering?

Speak with an experienced advisor to determine which strategy is best for you

Determining whether an active or a passive strategy, or a combination of the two, is appropriate for your particular situation can be difficult.

Because of this, we highly recommend you speak with an experienced financial advisor who can direct you to the resources and information you need to make an informed choice about which strategy is right for you.

We understand that every situation is unique, and our advisors are happy to provide a full range of investment options to fit your goals and circumstances.

If you have any questions about the different types of investments, or if you want to speak with a certified financial advisor, please reach out to find a wealth management team near you.

Commonly Asked Questions about Passive and Active Management

Do most active funds beat the market over time?

Over longer periods, many active funds underperform their benchmarks after fees. Success varies by category and time frame.

Are ETFs always passive?

No. Many ETFs are actively managed; “passive vs. active” describes the strategy, not the vehicle.

Why do small fees matter?

A 0.50% gap compounded over 20–30 years can mean a materially smaller ending balance.

Can passive strategies trigger taxes?

Yes. Any strategy can distribute gains. But many index ETFs are relatively tax-efficient; your outcome depends on the fund and account type.