Questions You Were Afraid to Ask: What's the Difference Between Passively Managed and Actively Managed Funds?

Investing can feel overwhelming, especially when faced with so many options. That’s why we created Questions You Were Afraid to Ask—to help break down the complexities of investing and empower you with the knowledge to make informed decisions.

Previously, we discussed the differences between stocks and bonds. But for many investors—especially those using an IRA or 401(k)—choosing individual stocks isn’t practical. That’s why most people invest through funds. But even here, a common question arises:

Questions You Were Afraid to Ask #4:

What’s the Difference Between Passively Managed and Actively Managed Funds?

If you’ve ever browsed through investment options in a retirement plan, you’ve likely seen funds classified as active or passive. But what do these terms mean, and how do they impact your investments?

Actively Managed Funds

An actively managed fund is one where a portfolio manager or team makes investment decisions about which securities to buy and sell, with the goal of outperforming a benchmark index (like the S&P 500) or mitigating market risk.

Considerations for Active Funds:

• Potential to outperform the market, but no guarantees.
• Portfolio managers may attempt to adapt to market conditions, identifying opportunities or minimizing risks.
• Some active funds focus on specific sectors or investment strategies that align with investor objectives.

Potential Risks of Active Funds:

• Higher fees due to management expenses and transaction costs.
• No assurance of outperformance—many active funds have historically underperformed compared to passive alternatives.
• Increased trading may lead to higher tax consequences for taxable accounts.

Passively Managed Funds

In contrast, passively managed funds seek to track a specific index, such as the S&P 500, by investing in the same companies at the same weights.

Considerations for Passive Funds:

• Lower costs due to minimal trading and management expenses.
• Historically, index funds have performed well over the long term, though past performance is not a guarantee of future results.
• Simplicity—investors don’t need to worry about manager decisions or frequent rebalancing.

Potential Risks of Passive Funds:

• No opportunity to outperform the market.
• Lack of downside protection during market downturns.
• May not be ideal for investors seeking specialized or sector-specific investment strategies.

Which One is Right for You?

There is no universal answer—it depends on your investment goals, risk tolerance, and time horizon.

• If you prefer lower costs and long-term diversification, a passive fund (like an S&P 500 index fund) may be a suitable option.
• If you are seeking active management and strategic opportunities, an actively managed fund could be appropriate, keeping in mind the associated risks and fees.
• Many investors diversify by combining both strategies, using passive funds for broad exposure and active funds for targeted investments.

What’s Next?

Now that you understand active vs. passive funds, the next step is to explore different types of funds. In our next post, we’ll discuss mutual funds, hedge funds, and exchange-traded funds (ETFs).

Your Questions Are Welcome

While we have a list of topics planned, we want this series to be as helpful as possible. Do you have a financial question you’ve been hesitant to ask? Is there a term or concept you’d love to have explained? Let us know—because this series is for you! Simply send us a message with your question or topic idea below.