Active vs. Passive Investing

There are really only two ways fund managers can manage your money: active management and passive management. The phrase “beat the market” generally refers to active management, where the fund manager picks investments that, for a certain period of time, generate a greater return than that of a comparable index (e.g., S&P 500, Dow, Nasdaq, etc.). Passive management, on the other hand, means that the manager mimics the investments held in an index. Subsequently, the return matches that of the mimicked index (though the return is reduced by expenses incurred). Each method has its pros and cons.

The Advantages of Passive Management

The biggest advantage of passive investing is that it's cheaper. Every time a fund manager performs a trade, it costs you money—and active managers often trade a lot. Passive portfolios only change when the index changes. Indices, for the most part, run unchanged for long periods of time, so you pay less in transaction costs.

Passive management is a no-brainer. The manager buys the stocks in the index, and at the end of the year, you both know that you did as well (or as poorly) as the index did. This is an advantage because it could be argued that the majority of actively managed investments may not beat their appropriate index over the long haul.

When you look over the span of the market over 10 years, 20 years, or 30 years, it becomes harder and harder to beat an index through active management. With a few exceptions, when the market is up, actively managed investments may have a hard time beating the market, and when the market's down, they may do much worse.

An Opportunity for Greater Growth

With active management you pay for the fund manager's ability to “hit the ball out of the park.” Active managers assemble their own portfolios independent of an index, which means they trade often. Plus, they have a staff of stock pickers and analysts to help. All of those salaries and trades add up to higher expenses for you, and decreases your overall return at the end of the year.

But active management gives a manager the opportunity to beat the index handily by selecting investments different from those held in the index, something passive managers can't do. An active manager can anticipate recessions and bear markets and move the portfolio around accordingly to limit losses. Passive managers must ride out the storm, falling as far as their index falls.

Only Time Will Tell

So, which form of investing is better? In the end, it all depends on your financial goals, your time horizon, the talent of your fund manager, and how much luck he or she gets. Though the odds are probably in passive management's favor, past performance is no indication of future results, and as with most things in life, only time will tell.

Disclosure: All indices are unmanaged and investors cannot actually invest directly into an index. Past performance is not indicative of future results. The Nasdaq Composite Index measures all Nasdaq domestic and non-U.S.-based common stocks listed on the Nasdaq Stock Market. The Dow Jones Industrial Average is a price-weighted average of 30 actively traded blue-chip stocks. The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks.