How Active And Passive Funds Work Differently
ArticlesWhether you’re building your portfolio, trying to diversify or considering new investments, understanding the difference between active and passive funds is extremely helpful. Both mutual funds and exchange-traded funds (ETFs) can be either active or passive.
The basics
Active and passive funds are fundamentally different in the way individual stocks and bonds within the funds are chosen. A fund’s portfolio manager selects the stocks and bonds for an active fund, while a passive fund tracks an index, like the S&P 500. The passive fund often uses a representative sampling method to “match” the characteristics of the index in the fund, and its intention is to reflect overall market performance.
Generally, active funds try to beat the market while passive funds try to reflect the market. Active funds usually have higher fees but offer different investment opportunities, while passive funds usually offer lower fees and attempt to lower taxable gains and losses by trading less often.
Side-by-side comparison
The two approaches differ in several ways. See a breakdown of some of the differences below:
| Active Funds | Passive Funds |
|---|---|
| Attempts to outperform the market | Does not try to beat the market because it attempts to track the market |
| Possibility of underperforming against the benchmark | There are no strategies in place to limit losses when the market is down |
| Portfolio managers have the flexibility to invest in special assets, which may offer distinct investment opportunities | Fund includes investments that are available to all |
| Higher fees because there’s more work involved in the management of the fund | Lower fees, which on average can be less than half that of an active fund |
| Could have more taxable capital gains and losses because the portfolio manager may trade more often | Usually has fewer taxable gains and losses because there’s less trading involved |
How to choose
Active and passive funds both have distinct benefits, but which will serve you best depends on your goals, assets and other considerations as an investor. In many cases, a mix of both types of funds is a great fit. That’s where an advisor comes in: to help you understand which active and passive funds are available to you, and factor in your risk tolerance and time horizon to determine how either – or both – may be an appropriate choice for your portfolio.
Next steps
Before implementing a new investment, it’s good to consider how it will fit into your financial plan:
- Research the historical returns and expense ratios.
- Determine your risk tolerance and timeline for the investment.
- Review your current situation and financial goals.
CONNECT WITH AN ADVISOR TO DISCUSS YOUR FINANCIAL PLAN
Investors should consider the investment objectives, risks, and charges and expenses of mutual funds and exchange-traded funds carefully before investing. The prospectus contains this and other information about these funds. The prospectus is available from your financial advisor and should be read carefully before investing.
Investing involves risk and investors may incur a profit or a loss. The S&P 500 is an unmanaged index of 500 widely held stocks. An investment cannot be made directly in this index. Keep in mind that the index performance does not include transaction costs or other fees, which will affect actual investment performance.
This material is being provided for information purposes only and is not a complete description, nor is it a recommendation. Material created by Raymond James for use by its financial advisors. The information contained herein has been obtained from sources considered reliable, but we do not guarantee that the foregoing material is accurate or complete. Raymond James is not affiliated with any other entity or individual listed herein. Investment products are: not deposits, not FDIC/NCUA insured, not insured by any government agency, not bank guaranteed, subject to risk and may lose value. © 2024 Raymond James & Associates, Inc., member New York Stock Exchange/SIPC. © 2024 Raymond James Financial Services, Inc., member FINRA/SIPC. Raymond James is a registered trademark of Raymond James Financial, Inc.
Sources: investor.vanguard.com; experian.com; investopedia.com; nerdwallet.com; investor.vanguard.com; thebalancemoney.com