Active vs passive investing: Pros and Cons
Active and passive investments are very different ways of investing and both come with pros and cons.
All investing has the same goal of building your wealth. There are different ways to get there though. Passive investing aims to follow the performance of either the overall market, or certain sections of it. Active investing relies on experts to manage things with the aim of giving you higher returns. But which is for you? We’ll explain the benefits and drawbacks here, so you can decide which suits you best.
Whether active or passive, investments can fall as well as rise and you may get back less than you've paid in.
What is Active Investing?
Fund managers are the key to active investing. They're employed to oversee an investment fund, using their knowledge to buy and sell the investments that make it up.
This involves detailed research on individual companies – like new products they’re creating, how their business fits with current trends in the overall economy and their senior management. For example, a company may have a new drug in the pipeline that could become a market leader, which would see their share price increase fast. A fund manager would aim to buy that company’s shares before they go up. They also look at wider things that could affect investments, like political changes and conflicts. Managers can act to sell shares if a company isn’t performing well, to try cut losses in the fund.
Pros of Active Investing
The biggest appeal of active investing is that fund managers aim to get higher returns than funds which track an index.
Fund managers also have the freedom to choose investments that make up the fund and the size of each one.
This lets them make changes quickly, which can help reduce losses if something like a market crash happens. For example, if a fund has a high percentage of company shares, the fund manager can sell some of them and move the money into safer investments like bonds or just hold more cash.
Cons of Active Investing
Using the expertise of a fund manager comes at a cost and actively managed funds will usually have higher fees than passive ones. This can cut into your profits and reduce the growth of your money over time.
You’re also relying on the fund manager’s strategy to outperform the market. This can mean taking bigger risks and any poor choices can harm your returns. It can be a bigger issue during downturns if the manager stays invested in companies which are more affected. The fund’s performance may also drop if a successful manager leaves, and another takes over.
Trying an active investment strategy without using a fund manager can also be very time consuming and difficult for a novice investor as it requires constant monitoring of your investments and lots of research.
What is Passive Investing?
Passive investing looks to match the performance of a market index like the FTSE 100 or S&P 500. It does this by creating funds that hold investments like shares or bonds in lots of companies that make up an index, and keeping buying and selling to a minimum. When the index rises, the investments in the fund should rise to match it.
Pros of Passive Investing
As they require less management and don’t trade investments as often as fund managers, passive funds will generally have lower charges than actively managed ones, which means investors keep more of any gains. As they only aim to track an index they can be less risky than actively managed funds where a manager is aiming to outperform the market, which can mean investing in companies or trends which may not succeed.
Cons of Passive Investing
Passive investing doesn't have the flexibility of active investing to change the balance of companies in a fund based on possible gains. For example, to invest heavily in a company that may have strong growth prospects.
Equally, when things are bad, investments in a passive fund won’t be sold or switched in reaction to any downturns, so investors will have to ride them out with the market.
Comparing Active and Passive Investing
In this video, Donato Boccardi, Head of Investments for Consumer Wealth at Aviva, explains the difference between active vs passive investing, outlining how each approach works and what investors should consider when choosing between them. Learn how active and passive strategies can play a role in building your investment approach.
Active vs Passive investing
Transcript for video Active vs Passive investing
Chapter 3:
Active vs Passive investing
This video is for educational purposes only. This should not be viewed as advice or recommendation to invest.
All investing, in particular your pension, has the same one goal, building your wealth for the future.
There are different ways to get there, though. In this chapter, we'll explore the benefits and drawbacks on both active and passive investing, so you can start to decide which is best for you.
The value of an investment can go down as well as up and you could get back less than invested.
Let's start with active investing. With this approach, the fund managers use their expertise to pick investments they believe will outperform the market. So when fund managers choose where to invest, they really get under the skin of a company.
They look at what's coming down the pipeline, for example new products, services or trends, and how businesses are run on a day-to-day basis. They even consider things like how committed the company is to sustainability and who's leading it. But it doesn't stop there.
They keep an eye on the bigger picture, politics, global events, anything that might shake the markets. If they spot a company that looks set to do well, they can buy more of it. And if things start to go south, they can act quickly to sell it and protect the value of the fund.
Now, the upside of this approach is pretty clear. Fund managers aim to beat the market, so if they get it right, there's potential for higher returns. They have the flexibility to respond fast when markets shift, which can be a real advantage in uncertain times.
Back when I was working in Singapore, I remember one of our regular investment calls with colleagues across Aviva. During that session, there was a deep dive into the electric scooter industry and how a major boom was on the horizon. Insights like that can be game-changing, but they require significant effort and expertise to uncover.
Actively managed funds tend to have higher fees, and over time, those fees can eat into your profits and slow down your money's growth. While a fund manager aims to outperform the market, there's no guarantee they will. Their strategy might involve taking more risk, and poor decisions can hurt returns.
If a successful manager leaves the company, or if they stay invested in companies that take a hit, performance can drop. So if you're thinking of doing active investing yourself, just know it's not a passive hobby. It takes time, research, constant monitoring, and a fair bit of confidence.
I'd say it's not impossible, but definitely not for everyone. Passive investing, on the other hand, is a bit like setting your GPS and letting it guide you. You're not trying to outsmart your route, just follow it steadily.
Instead of trying to beat the market, you aim to match it. This is usually done by tracking something called an index, like the FTSE 100, which is made up of 100 biggest companies in the UK, or the S&P 500 in the United States. Funds that follow these indexes invest in all the companies that make up the index.
Once the fund is set up, there's not much buying or selling. The idea is simple. When the index goes down, the fund also goes down.
When the index goes up, the fund goes up too. Now, the benefits? It's usually cheaper. Passive funds tend to have lower fees than active ones, which means you get to keep more of any gains.
It's also less risky in some ways. You're not chasing trends or betting big on individual companies, you're just following the market. But there are trade-offs.
Passive funds don't have the flexibility to jump on opportunities. If one company looks like it's about to take off, a passive fund cannot suddenly invest more in it. And when the market dips, you ride that wave too.
There's no quick switch to avoid the drop. So it's a steady, long-term approach, great for people who want simplicity and lower costs, but it's not built for reacting to fast-moving changes. Taking both sides of investing into account, this is why most pensions use a mix of active and passive strategies, combining the potential for growth with the stability of a long-term approach.
The value of all investments can go down as well as up and you could get back less than what you’ve paid in.
So how do you choose between active and passive investing? Well, here's a simple way to think about it. Active investing has higher fees and more involvement, but it offers the potential to outperform the market. It can suit those seeking more opportunities and willing to take on more risk.
Passive investing typically has lower costs and aims to mirror the market performance, making it appealing for investors who value simplicity and consistency, though it limits the chance of beating the market.
Both approaches work best if you're in for the long run, typically five years or more. So before you decide, ask yourself, what matters more? The potential to outperform the market and tailor your strategy, or a lower-cost one that tracks the market performance?
This video is for educational purposes only. This should not be viewed as advice or recommendation to invest. Investing offers the potential for better returns than cash savings over the long term (5+ years).
But there are risks, the value of your investments may go down as well as up, and you may get back less than invested. If you want advice on investment choices, then we’d recommend speaking to a financial adviser. There may be a charge for advice.
This video is part of our wider Each chapter is designed to work alone, so you can jump in wherever you like.
| Active | Passive | |
|---|---|---|
| Cost | Higher fees to cover the cost of managing the fund. | Lower fees as the fund tracks the market, needing less management. |
| Goals | Aims to achieve higher returns than the overall market or a section of it e.g. Technology. | Aims to deliver returns that match increases in an index covering part or all of the market. E.g. the Nasdaq technology index. |
| Best for | Investors looking for higher returns, who are happy to rely on the performance of a fund manager | Investors looking for steady growth over a long period. |
Which Strategy is Right for You?
It all comes down to personal choice. If you’re hoping to get higher returns than the overall market and don’t mind higher fees and maybe higher risks by putting your trust in a fund manager, then active investing may suit you better.
If you’re happier to track the market in a way that has a lower cost, and you can sit back knowing your investments are likely to experience some ups and downs with the overall market, then passive investing may suit you better.
If you’d like to learn more about investing, you can check out the products Aviva offer.
With either route, investing works best over at least five years. The value of any investments can fall as well as rise, and you may get back less than you’ve put in.
If you’re not sure whether investing is right for you, or want advice on passive or active choices then we’d recommend speaking to a financial adviser – there will usually be a charge for advice.
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