Active vs. Passive Funds: What They Mean and How to Differentiate Them

Beginner investors will often encounter unfamiliar terms, including active and passive fund investing. What is an actively managed vs. passively managed fund?

Here are some examples of both, and how they differ—including whether one is better than the other for retail investors.

What it means when an investment fund is actively managed

Actively managed funds are handled by a specific manager or team that decides how to invest using the fund's money. 

They tend to be more expensive than passively managed funds (aka a higher expense ratio) and are intended to outperform benchmarks like specific indices (like the S&P 500).

One advantage of an actively managed fund is flexibility. Fund managers don't have to follow a specific index. They can buy any shares that they think will appreciate in the market, often trading intraday for optimum performance.

Active fund managers can also manage their risk more efficiently, hedging their bets for each investment they choose and practicing tax loss harvesting.

Examples of actively managed funds in the U.S. market

An exchange-traded fund (ETF) is an actively managed basket of securities that follows an underlying index. You can also find them in the Middle East, such as on the Nasdaq Dubai. In the US, active ETFs include the ARK Innovation ETF (ARKK).

Investment companies offer target date funds (TDF) to retail investors as a retirement vehicle. The date of the fund is usually in the fund name and refers to the date retail investors will start withdrawing money from the security. You can also invest in a TDF for a closer date as an alternative way to save for medium-term goals.

How a passively managed fund is different

A specific manager or investment team does not operate a passively managed fund. These funds are typically automated with some human intervention. 

Passive funds are usually cheaper than their active counterparts. They mirror specific indices but are meant to match—not beat—the index performance.

Some examples of passive funds

Robo-advisors are fully automated technology platforms that build and manage individual portfolios based on information submitted by individual investors. They often use passive indexing strategies. In the US, Wealthfront and Ellevest are popular robo-advisors.

Index funds mirror an index and are usually well-diversified investments meant to meet the market's performance. SPY is an index fund that tracks the S&P 500.

How fees differ between active and passive funds 

Active funds have higher expense ratios (fees charged to cover operating and administrative expenses) than passive funds. 

Active funds typically have expense ratios of 0.5–0.75%. Passive funds have ratios closer to 0.2–0.3%, as their operating and administrative costs are lower.

Which type of fund is right for you?

As a retail investor, you can take a hybrid approach with active and passive funds in your portfolio.

This strategy allows investors to take the risk of outperforming the market through active investing and meet the market through passive investing. 

Take stock of your risk tolerance, and define what you believe is a good investment that will grow your portfolio.