Passive vs. Active Portfolio Management: What's the Difference?

Investors have two main investment strategies that can be used to generate a return on their investment accounts: active portfolio management and passive portfolio management. These approaches differ in how the account manager utilizes investments held in the portfolio over time. Active portfolio management focuses on outperforming the market compared to a specific benchmark, while passive portfolio management aims to mimic the investment holdings of a particular index.

Investors who implement an active management approach use fund managers or brokers to buy and sell stocks in an attempt to outperform a specific index, such as the Standard & Poor's 500 Index or the Russell 1000 Index.

An actively managed investment fund has an individual portfolio manager, co-managers, or a team of managers actively making investment decisions for the fund. The success of an actively managed fund depends on combining in-depth research, market forecasting, and the experience and expertise of the portfolio manager or management team.

Portfolio managers engaged in active investing pay close attention to market trends, shifts in the economy, changes to the political landscape, and factors that may affect specific companies. This data is used to time the purchase or sale of investments in an effort to take advantage of irregularities. Active managers claim that these processes will boost the potential for returns higher than those achieved by simply mimicking the stocks or other securities listed on a particular index.

Since the objective of a portfolio manager in an actively managed fund is to beat the market, he or she must take on additional market risk to obtain the returns necessary to achieve this end. Indexing eliminates this, as there is no risk of human error in terms of stock selection. Index funds are also traded less frequently, which means that they incur lower expense ratios and are more tax-efficient than actively managed funds.

[Important: Active management traditionally charges high fees, and recent research has cast doubts on managers' ability to consistently outperform the market.]

Passive management, also referred to as index fund management, involves the creation of a portfolio intended to track the returns of a particular market index or benchmark as closely as possible. Managers select stocks and other securities listed on an index and apply the same weighting. The purpose of passive portfolio management is to generate a return that is the same as the chosen index instead of outperforming it.

A passive strategy does not have a management team making investment decisions and can be structured as an exchange-traded fund (ETF), a mutual fund, or a unit investment trust. Index funds are branded as passively managed because each has a portfolio manager replicating the index, rather than trading securities based on his or her knowledge of the risk and reward characteristics of various securities. Because this investment strategy is not proactive, the management fees assessed on passive portfolios or funds are often far lower than active management strategies.

Index mutual funds are easy to understand and offer a relatively safe approach to investing in broad segments of the market.

• Active management is when managers actively pick investments in an effort to outperform some benchmark, usually a market index.
• Passive management is when a fund manager attempts to mimic some benchmark, replicating its holdings and, hopefully, performance.
• Active management funds tend to have high fees, and recent research has called into question their ability to outperform the market with any consistency.