Active vs Passive Investing Definition + Key Differences

The funds’ total returns, though, have been less predictable than their sales results. As the following table indicates, Vanguard’s active large-company funds have performed much like its index funds. (In addition to the growth- and value-style funds, the table also shows how the company’s active large-blend funds have fared.) From this admittedly small sample size, there is no evidence of index-fund superiority.

Active investors research and follow companies closely, and buy and sell stocks based on their view of the future. This is a typical approach for professionals or those who can devote a lot of time to research and trading. The investing information provided on this page is for educational purposes only. NerdWallet, Inc. does not offer advisory or brokerage services, nor does it recommend or advise investors to buy or sell particular stocks, securities or other investments.

Should You Ever Pick an Active Fund or Investing Style?

We create a dummy variable for the subset of active ETFs that are within the top quartile of active ETFs by portfolio turnover, DiActiveInForm⁠, as a simple proxy for ETFs that are active in form. We then rerun the flow–performance sensitivity regressions for just the subsample of active ETFs, including an interaction term with this active-in-form proxy. More germane for our focus is research by Garleanu and Pedersen (2019) and Cremers et al. (2016) who examine facets of the decisions to invest passively or actively.

active vs passive investing studies

In contrast, the very active ETFs (top two quadrants, and in particular the top right-hand side quadrant), are far more numerous and tend to be smaller, results in line with Hypothesis 4. Such diseconomies of scale for active management are also predicted by Berk and Green (2004) and Pastor, Stambaugh, and Taylor (2020). There are, however, a few fairly large active ETFs with average AUM greater than $10 billion. These large active ETFs tend to be the active in function ETFs, such as sector ETFs, while the smaller active ETFs tend to be active in form (later we empirically separate these two types of activeness). To capture the diversity of this middle ground, we propose a paradigm for these active ETF products based on form and function.

Cons of Active Investing

This is mainly due to the buy-and-hold strategy that allows investments to accumulate wealth over the long term. Although passive funds may underperform at some point in the market, this typically doesn’t last very long. Our results show that most ETFs are active investment vehicles, they get used in an active manner by investors who frequently turn over positions in ETFs, they have become more active through time, and they have increased competition across the asset management industry. In this section, we turn to some broader implications of ETF activeness, but caution at the outset that our goals here are modest. The evolution of ETF products coincides with a range of other market changes including high-frequency and algorithmic trading, regulatory changes, new quantitative trading strategies, and the like.

  • The following proposition characterizes the portfolio holdings of the informed investors.
  • The cost of active investment can also increase in I, though, if the search cost rises sufficiently.
  • Therefore, even ETFs in which the holdings are passively linked to an underlying index can contribute to informational efficiency through the active trading by investors.
  • In 1992, Vanguard already managed two actively run large-growth funds and three large-value funds.

Lower information costs also increase active management (relative to self-directed investment and passive management), consistent with the development in the 1980s and 1990s. Over a recent 10-year period, active mutual fund managers’ returns trailed passive funds consistently, says Kent Smetters, professor of business economics at Wharton. Investors in passive funds are paying for computer and software to move money, rather than a high-priced professional. So passive funds typically have lower expense ratios, or the annual cost to own a piece of the fund. Those lower costs are another factor in the better returns for passive investors. Passive investing is buying and holding investments with minimal portfolio turnover.

All this evidence that passive beats active investing may be oversimplifying something much more complex, however, because active and passive strategies are just two sides of the same coin. Familiarity with fundamental analysis, such as analyzing company financial statements, is also essential. Morgan Stanley Wealth Management is involved in many businesses that may relate to companies, securities or instruments mentioned in this material. Active and passive investing don’t have to be mutually exclusive strategies, notes Dugan, and a combination of the two could serve many investors.

While some ETFs are active in form meaning that the portfolio of assets tracked by the ETF is chosen with the objective of generating alpha, other ETFs are active in function meaning that they are used by investors as building blocks of active portfolios. Their ability to be easily and cheaply traded is what sets ETFs apart from index mutual funds and enables activeness in function. We extend the Berk and Green (2004) model of mutual fund management to incorporate these new investment products, demonstrating a role for what we call “aggressive–passive” investing with ETFs. Our model suggests a variety of hypotheses regarding fees, sizes, and fund flows across these investment products and their competitive impact on investment management. We also consider the larger question of why activeness matters for the market more generally.

Model and Equilibrium

We argue that the growth in ETFs, by filling the void in the spectrum between active and passive products, need not change the equilibrium level of activeness in the market. We model how investors allocate between asset managers, managers choose portfolios of multiple securities, fees are set, and security prices are determined. In fact, all inefficiency arises from systematic factors when the number of assets is large.

active vs passive investing studies

His work has appeared in CNBC + Acorns’s Grow, MarketWatch and The Financial Diet.

In other words, factor inefficiency dominates overall market inefficiency to a surprising extent. The standard “APT of returns” says that risk premiums must be driven by systematic factors. The economics behind the APT is that, if certain assets delivered abnormal returns relative to their factor loadings, then investors could earn a return with a risk that can be diversified away, and such near-arbitrage profits are ruled out in equilibrium.

Our notion of activeness is the extent to which the ETF deviates from the completely passive strategy of holding every component of the market in value-weighted measures. The horizontal axis measures the Active Return Deviation of the ETFs, while the vertical axis measures their Activeness Index. For each ETF in each quarter, we measure the values of Activeness Index and Active Return Deviation and then take time-series averages for each ETF. In Panel B, larger circles are used for more actively traded ETFs measured by the ETF’s secondary market turnover (volume scaled by shares outstanding). To give an example, consider the hedge fund Twin Tree Management LP that has approximately $2.5 billion in AUM and is regarded as a high-turnover, large-cap focused, highly active fund.

The indices selected by Morgan Stanley Wealth Management to measure performance are representative of broad asset classes. Morgan Stanley Wealth Management retains the right to change what is one downside of active investing representative indices at any time. There is no correct answer on which strategy is “better,” as it is highly subjective and dependent on the unique goals specific to every investor.

Index designers will typically charge a fee to ETF providers to use the index, which is how they monetise their skill, which the ETF ultimately passes on as a fee to investors much like a skilled fund manager monetises their skill through the fees they charge investors. This figure provides four snapshots of ETF activeness at different points in time (2001, 2006, 2011, and 2016). The horizontal axis is the ETF’s Active Return Deviation and the vertical axis is the ETF’s Activeness Index. Bigger circles are used for bigger ETFs in terms of AUM (biggest circles are ETFs with more than $10bil of holdings on average, followed by $1bil to $10bil, followed by $100mil to $1bil, followed by under $100mil). There is much debate about active vs. passive investing and which one is better, but in reality, a combination of both strategies may offer more portfolio diversification.

To understand the economic forces affecting the evolving forms of active and passive fund management, we need a model capable of including a spectrum of funds from active to passive. We modify the model of mutual fund management developed by Berk and Green (2004) and expanded by Berk and van Binsbergen (2015) to include passive investments and we use this framework to show how ETFs can be characterized in equilibrium. What characterizes an investment product as being active or passive and why does it matter? In this section we develop theoretical arguments to guide our empirical investigation.

The authors do not use either individual fund data or an activeness metric, and instead aggregate their data by segments. This aggregation may understate the strength of this flow–performance relation among ETFs.29 Moreover, much has changed in the ETF universe since the period considered by these authors (their sample ends in 2012), with the rise of active ETFs particularly pronounced in recent years. A natural question is whether this performance–flows relation has changed as well. Section 3 considers comparative statics with respect to some key changes in the market, namely, the costs of active and passive investing.

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