Active vs. Passive Portfolio Management

While developing and maintaining an investment strategy, you may come across active and passive methods of putting together a portfolio. Both have fundamental differences, however, and fit different types of investor profiles and risk tolerances. So, how can you decide which is right for you?

In this article, we’ll define active and passive portfolio management and emphasize what makes them different. Additionally, we’ll offer some analysis on deciding which is right for you and the value a financial advisor can add to that process.

What Is Active Management?

In simplest terms, active investing is the strategic aim of investors or portfolio managers to select investments that outpace or “beat” the market. As its name suggests, this involves research and decisive short- and long-term trades to achieve competitive performance with market benchmarks, such as the S&P 500 or the Dow Jones Industrial Average (DJIA). This can be demanding and risky, sometimes necessitating a high level of investing expertise and analytical skill.

Actively managing a portfolio “requires a hands-on approach, with investors closely monitoring market movements, economic trends and political developments,” says Kristopher Whipple, partner and financial advisor at Kristopher Curtis Financial in Nashville, Tennessee. “Active investors aim to buy assets when prices are low and sell when prices are high, capitalizing on short-term market fluctuations.”

What kind of assets would make up an active portfolio? According to Whipple, this approach is “dynamic and often includes a mix of individual stocks, sector-specific ETFs, alternative investments and a laddered bond strategy.” Because it requires flexibility and proper timing over the market, the investments should be relatively liquid, focused on returns, and easy to switch to new ones. “Active portfolios often shift allocations based on market conditions, sector performance and macroeconomic trends,” adds Whipple.

As mentioned, active portfolio management can be risky and complex. It requires awareness and an understanding of market conditions and investment performance, allowing an investor to outperform indexes. As such, it can be largely inaccessible for average individuals to tackle on their own. To implement an active strategy, it’s not uncommon to work with an experienced financial advisor who will do it on your behalf or alongside your input.

What Is Passive Management

Unlike active investing, a passive portfolio adopts a more hands-off approach where investors do as little as possible to maintain or turn over their investments. Often, this involves seeking to match the performance of established benchmarks (e.g., the S&P 500, Russell 2000, or DJIA), riding the wave of the market over a long period.

Investors often buy shares of passively managed index funds that track the market indexes they want to follow to accomplish a passive portfolio allocation. By doing so, they gain an indirect ownership of the companies proportional to the shares of the fund they own.  

“A passive portfolio typically consists of investments that require minimal management, such as dividend-paying stocks, broad-market index funds (e.g., S&P 500 ETFs) and bond mutual funds,” explains Whipple. “These investments are chosen for their stability, long-term growth potential and ability to generate income through dividends.”

Passive investing, as noted, is often a long-term strategy. By following the general trajectory of benchmark performance, investors bank on the notion that markets will continue to increase—and so will their principle. For instance, if you invest each year in an S&P 500 index fund from a young age, the hope is that this money will grow and compound along with the markets to position you well for long-term goals such as retirement.

Whipple outlines the concept below:

A common question in investing is, “Is the market efficient?” Looking at historical data, the S&P 500 has delivered positive average returns over extended periods, leading many to believe that the market, in general, is efficient. Investors who adopt a passive approach often buy into the market through index funds like SPY or VOO, or they follow Warren Buffett’s philosophy of investing in large, stable companies with strong dividends. This strategy relies on the market’s historical tendency to appreciate over time, allowing investors to grow their wealth without actively managing their holdings.

Comparing Active and Passive Portfolio Differences

Active and passive styles of assembling and managing a portfolio have significant contrasts and fit different investor styles. For example, the former involves a more involved commitment to hitting specific goals, while the latter is less hands-on and more accessible to the average person. However, they’re also dissimilar regarding details such as overall risk and cost.

Below is a more specific overview of the ways the two differ:

Investment Strategy and Performance

Primarily, active and passive portfolios are very different because of their overarching investment strategy. As mentioned, an active portfolio strives to outperform established benchmarks, sometimes with a shorter holding period. Rather than tracking an index, investors or managers must select the right investments to beat the market and reach desired returns.

Conversely, a passive allocation generally requires little maintenance and follows the performance of market trends. “Passive portfolio management is used to track an index with minimal trading” and “is geared towards low-cost, long-term growth,” says Michael Santiago, CRPC^™, Senior Financial Editor at RetireGuide.com.

Risk

Active and passive portfolios also present different risk levels. Ultimately, this helps dictate the type of investor that may use them or which a financial advisor may recommend.

Because an active style’s objective is to beat the market, they may trade more frequently and be in danger of market volatility and losses. This can be a potential “major downside,” says Whipple, adding that “many investors fail to consistently beat the market, and transaction costs, fees and taxes can eat into returns.” In this way, an active portfolio is often an option for individuals with a higher risk tolerance, despite its potentially loftier gains.

“Active management has more flexibility with higher returns (potentially), but has much higher fees and inconsistency performance compared to passive,” says Santiago, highlighting that “financial advisors are equipped to explain” this fact to clients considering how to structure their portfolios.

As Santiago suggests, passive portfolios generally come with a reduced level of risk. While they can be prone to market volatility caused by external geopolitical and industrial factors, the markets generally tend to follow an upward trajectory (e.g., see S&P 500 historical data).

“By dollar-cost averaging into an S&P 500 index fund, investors can benefit from long-term market growth without the need for constant monitoring or decision-making,” says Whipple. “Since 2001, the S&P 500 has averaged around 8.5% annual returns—an attractive return for those with a long-term horizon.”

Commitment

Another distinction between the two investing philosophies is their necessary commitment. Simply put, an active portfolio demands much more than a passive one. “This strategy requires careful timing, research and ongoing market analysis,” explains Whipple.

Passive portfolios, however, are more user-friendly for the regular person. This is because they involve selecting one or a few passively managed index funds that match a desired market. Though this still deserves research and correct vetting of the ideal assets for your needs, it requires less firsthand work than an active strategy and is more straightforward for a financial advisor or robo-advisor to prescribe.

“If an investor prefers a hands-off and low-cost approach then a passive style could be a better choice,” Santiago advises.

Cost and Fees

Finally, active and passive management styles come with different costs and fees. That is, as we’ve touched on, active investing comes at a higher expense. One reason is that it “typically involves frequent trading, commission fees and potentially higher advisory fees,” Whipple says. “Many brokers charge commissions per trade, and actively managed mutual funds or hedge funds usually come with expense ratios and performance-based fees,” he continues.

Due to its smaller commitment and trading frequency, passive portfolio management includes lower costs. You’ll still face paying expense ratio fees and brokerage expenses while trading but you could reasonably expect to see smaller expenses since index funds and passive exchange-traded funds (ETFs) “require less active oversight,” Whipple points out.

Which Approach Should You Choose?

Deciding between active and passive styles for your portfolio will ultimately hinge on three primary factors: your risk tolerance, goals, and time horizon. Having an acute understanding of these will, ultimately, help you gain a stronger grasp on the kind of investor you are and which direction to go.

As mentioned, an active portfolio will require a serious ongoing responsibility to research and monitoring and comes with more risk; therefore, taking this sole route may not be the best option for most people. Unless you have the knowledge or motivation, you’ll likely need the help of an investment advisor to manage and construct your portfolio properly—which can add more costs and commitments.

Because of their hands-off nature, lower maintenance and costs, and longer holding terms, passive investing strategies are more accessible to most people. Thus, they can be helpful for those with long time horizons and a lower risk preference. While a professional can help, this strategy is possible for investors to handle on their own or with an automated investing service.

“Passive management is ideal for those who prefer a ‘set-it-and-forget-it’ approach, especially if they have a long investment horizon of 15 to 30 years before needing to access their funds,” says Whipple. “Conversely, investors who enjoy market research, economic analysis and taking calculated risks may find active management more engaging.”

While both philosophies have their merits and pitfalls, it’s also possible, however, to implement a hybrid style. This would include a mix of both styles and types of investments in your portfolio, For instance, Whipple says, you might have “a core portfolio of passive investments while allocating a portion to active trading,” allowing you to experiment and branch out without the risk of derailing your plans. Below, he describes one possible method he uses when working with clients as a financial advisor:

We often recommend clients set up a “cocktail account”—a separate investment account where they can experiment with active investing in a controlled, enjoyable way, without jeopardizing their long-term financial goals.

As you work to understand the portfolio approach for you, consider consulting a financial advisor’s experience. They’ll be able to assess your investor profile—including your goals, risk tolerance, and time horizon—and provide detailed recommendations. Make sure, however, to meet with a professional who upholds a fiduciary duty and gives advice according to your best interest rather than to earn a commission.

You can use a free matching service, such as this one, to find a reputable advisor. After answering a short list of questions about your goals and circumstances, it will match you with a fiduciary professional.