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Understanding active and passive mutual funds

Learn more about differences between these two investment types.

If you’re interested in investing in mutual funds or exchange-traded funds (ETFs) – or you already have some in your portfolio – you may be wondering what exactly the difference is between an active and a passive fund.

The subjects

An active fund comprises stocks and bonds that have been selected by a portfolio manager for the 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 reflect the market.

The testimony

Here’s a summary of how the two approaches differ.

Active funds

Passive funds

Attempts to outperform the market

Does not beat the market because it tracks 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 is transparent because you always know exactly what it’s invested in

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 a managed fund

Could have more taxable capital gains because the portfolio manager may trade more often

Usually has fewer taxable gains because there’s less trading involved

The takeaways

Both active and passive funds have their benefits, and much of the decision to go with one or the other will be based on the investor in question. Your advisor can help factor in your risk tolerance and time horizon to determine how either – or both – may be an appropriate fit for your portfolio.

Before you make any mutual fund or ETF investments:

  • Research the historical returns and expense ratios
  • Determine your risk tolerance and timeline for the investment
  • Speak to your advisor about your current situation and financial goals

The S&P 500 is an unmanaged index of 500 widely held stocks. An investment cannot be made directly in this index.

Sources:investor.vanguard.com; experian.com; investopedia.com; nerdwallet.com; investor.vanguard.com; thebalancemoney.com