By Scott Roark, MBA, PhD | September 18, 2020

In this blog post, I want to talk about the characteristics of passive and active investing and how those terms relate to activities frequently associated with investing.

For a working definition, I am going to consider passive investing as the set of activities and decisions that is consistent with an investor seeking to match the performance of their benchmark.  The benchmark would be consistent with the level of risk that is appropriate for the investor – consider for simplicity a 60% equity, 40% bond (60/40) portfolio.

For active investing, a good working definition is the set of activities and decisions that an investor takes to beat the performance of their benchmark.  Again, the benchmark would be consistent with the level of risk for the investor.

Let’s talk about that most important of decisions for an investor – their asset allocation.  This is really divorced from the whole active/passive discussion – at least when talking about the strategic asset allocation.  This is a decision that is made with an eye on the risk appetite, stage in life, types of assets, amount of assets, presence of guaranteed secure income, etc.  For some people this might be a 20/80 allocation and for others perhaps it is 80/20.

While the strategic asset allocation doesn’t really touch on active vs. passive, the tactical asset allocation does.  This is where certain investors/strategists/managers will adjust their target stock/bond mix based on market conditions and more importantly where they think the market will go in the near future.  This is trying to beat the market by tweaking things.  For instance, if there has been a big run up in equities, perhaps the active investor will decrease their allocation from the target 60/40 allocation to 50/50 because the fear is that the market will have a correction and by tweaking the asset allocation, the portfolio will do better than the 60/40 benchmark.

There is another important part to this asset allocation discussion.  In the absence of rebalancing a portfolio, an investor who does nothing after a run up in equities is really making an ACTIVE decision to be overweight equities because they will most likely have a higher proportion of equity than their target allocation.  It is a bit of a paradox, but by neglecting the account, the investor is effectively making a bet that they will do better than their 60/40 benchmark.  So periodic rebalancing is actually an important part of PASSIVE investing – keeping your portfolio allocated in a way that is consistent with your benchmark.

By far the most common characteristic of investing that people think about in the active vs. passive discussion is the actual investment they are picking.  A broad-based market index like the total stock market index or the S&P 500 index is a passive approach to the choice of what to buy.  Buying a mutual fund where the fund manager is trying to uncover undervalued stocks, on the other hand, is consistent with an active approach to investing.  Typically, there is a direct cost involved here.  Passive index funds or ETFs typically have VERY low expenses (less than 0.1%).  And while the expense ratios associated with active funds have come down dramatically over the years, many of these funds are still close to 1% (or more).  These higher fund expenses typically come at a cost to the investor:  Passive funds consistently beat actively managed funds over time.  A recent Morningstar report ( showed that less than 10% of actively managed large cap funds beat their passive benchmark over the most recent 10 year period ending in June 2020.  For all funds (large, mid, small, international, etc.), only 24% of actively managed funds beat their passive counterparts over that time.   The biggest reason is those fees.

There is one other critical component to the active vs. passive discussion and that is the amount of trading and attempted market timing involved.  Active investors try to time the market and are usually much more frequent traders than passive investors.  This usually leads to underperformance AND to tax inefficiency.  Study after study shows that investors who trade frequently underperform those who hold onto investments.  I’ve seen multiple reports of one particularly interesting study from Fidelity when they looked at which types of clients had the best performance between 2003 and 2013.  They found that the customers with the best performance were the ones who were dead or who were inactive (i.e. they forgot they had an account).  In other words, they were messing around with their investments – trying to time the market, buy the hot stock or guess which sector was about to take off.

While this is not an exhaustive list of all the ways an investor could try to “beat the market” (sector rotation, stock selection, interest rate forecasting, exotic investments, cryptocurrency, etc.), this hits on a few common differences between active and passive.

At our firm, we choose to use a passive approach to investing for a few reasons.  First, it has been shown over time to do well in comparison to benchmarks.  Jim has talked repeatedly in podcasts and we’ve had a number of blog posts that touch on the importance of benchmarking and the passive approach holds up well when comparing to the gold standard of performance.

Second, passive investing is a tax-efficient way to invest.  By minimizing trading, capital gains and the associated taxes are kept low.

And importantly, passive investing is relatively easy to implement and monitor.  With periodic rebalancing it is pretty easy to “set it and forget it” and look up after 5 or 10 years and be surprised at how well an account has performed – how much an account has grown (if you are in the accumulation phase) or how well an account has held up (if you are in the harvesting phase).