Regardless, the results referenced here and the overall body of evidence do not provide particularly compelling support in either direction. As we discuss below, even if the outperformance of active in down markets is accepted as fact, practical implications likely negate any benefit that the average investor could receive from it. Expenses are no doubt an important consideration and apply to both passive and active strategies. Passive strategies tend to cluster right below their respective benchmarks due to both expenses and tracking error. Expenses for active managers will be higher, but the differential between the lowest-expense active strategies run by large managers who pass on scale advantages to participants, and those of passive managers, may not be very substantial. 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.

•   Because passive funds use an algorithm to track an existing index, there is no opportunity for a live manager to intervene and make a better or more nimble choice. Maintaining independence and editorial freedom is essential to our mission of empowering investor success. We provide a platform for our authors to report on investments fairly, accurately, and from the investor’s point of view. We also respect individual opinions––they represent the unvarnished thinking of our people and exacting analysis of our research processes.

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Lower information costs also increase active management (relative to self-directed investment and passive management), consistent with the development in the 1980s and 1990s. The idea, known as “Samuelson’s dictum,” is that active investors have stronger incentives to correct (micro) inefficiencies in relative prices than to correct the overall (macro) price level. For example, active investors will ensure that the price difference between General Motors and Ford is close to efficient, but active investors may leave all stocks overvalued.

That’s why it’s a favorite of financial advisors for retirement savings and other investment goals. Passive, or index-style investments, buy and hold the stocks or bonds in a market index such as the Standard & Poor’s 500 or the Dow Jones Industrial Average. A vast array of indexed mutual funds and exchange-traded funds track the broad market as well as narrower sectors such as small-company stocks, foreign stocks and bonds, and stocks in specific industries. While some passive investors like to pick funds themselves, many choose automated robo-advisors to build and manage their portfolios. These online advisors typically use low-cost ETFs to keep expenses down, and they make investing as easy as transferring money to your robo-advisor account. When you own tiny pieces of thousands of stocks, you earn your returns simply by participating in the upward trajectory of corporate profits over time via the overall stock market.

The Most Favorable Result May Come from Combining Active and Passive Strategies

It doesn’t require the same level of skill or time commitment, so the fees are substantially lower than they are for an actively managed fund. Because the passive fund follows an index, the investment returns will generally be similar to the performance of the index as a whole (before fees). The approach of collecting share prices and performance data reflects a deductive and quantitative approach. Cross-sectional data has been collected consisting of active equity mutual funds’ prices from publicly accessible financial websites and databases. The evidence and findings of the empirical analysis is presented through descriptive statistics, measurements, correlation, and ranking, which reflects a deductive data analysis.

We sell different types of products and services to both investment professionals and individual investors. These products and services are usually sold through license agreements or subscriptions. Our investment management business generates asset-based fees, which are calculated as a percentage of assets under management. We also sell both admissions and sponsorship packages for our investment conferences and advertising on our websites and newsletters. This strategy provides a balance between the passive approach’s long-term consistency and the active approach’s potential for higher returns or specialised investments.

Disadvantages of active investing

These studies don’t put emphasis on actual asset-based analysis, and they therefore do not account for the size of each fund. After all, passive investing may be more cost efficient, but it means being tied to a certain market sector — up, down, and sideways. Active investing costs more, but a professional may be able to seize market opportunities that an indexing algorithm isn’t designed to perceive.

active vs passive investing studies

But analysts know that their investments, passive or active, can and should have better-than-average returns. In the passive realm, it comes down to figuring out which manager and strategy can provide the cheapest and most efficient beta exposure with low tracking error to the benchmark. 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. Active investors pay more fees for research, trading, and management, which eat into returns over time (we discussed this in the pros and cons section above).

Passively managed portfolio strategy

Successful passive investors keep their eye on the prize and ignore short-term setbacks—even sharp downturns. Whenever there’s a discussion about active or passive investing, it can pretty quickly turn into a heated debate because investors and wealth managers tend to strongly favor one strategy over the other. While passive investing is more popular among investors, there are arguments to be made for the benefits of active investing, as well. A final point is that we are assuming that investors are able to access their desired active funds without paying an up-front sales load or a material commission. If this is not the case, and an investor is subjected to a front-end cost of 1%, 2% or even more, the level of active outperformance that must be achieved in order to justify the switch from passive would be even greater.