Active and passive investing are two different ways to manage an investment portfolio. Passive investing generally aims to track a market index, while active investing generally aims to make decisions that could outperform a benchmark or achieve a specific outcome.
This guide explains how active and passive investing work, how they differ, the role of ETFs, and what investors should consider before choosing between them.
Capital at risk. The value of your investments can go down as well as up, and you may get back less than you invest. This article is for general information only and is not personal advice.
Active vs passive investing: at a glance
| Feature | Passive investing | Active investing |
|---|---|---|
| Main aim | Track an index | Outperform or improve on a benchmark |
| Management style | Rules-based | Fund manager-led |
| Typical cost | Often lower | Often higher |
| Holdings | Usually follow an index | Chosen by a manager or team |
| Main risk | Market risk | Market risk plus manager risk |
| Common ETF type | Index-tracking ETFs | Active ETFs |
Neither approach is automatically better. The right choice depends on the investor’s goals, costs and risk appetite.
What is passive investing?
Passive investing is an approach where a fund aims to track the performance of a market index.
For example, a passive S&P 500 ETF aims to track the S&P 500 Index. A passive FTSE All-World ETF aims to track the FTSE All-World Index. The fund is not aiming to choose companies that will outperform. Instead, it aims to replicate the index as closely as possible, usually at a relatively low cost.
Passive investing is popular because it’s simple, transparent and cost-efficient. Investors can see what index the ETF tracks, understand the broad exposure and use it as a building block in a portfolio.
However, passive investing doesn’t mean avoiding losses. If the index falls, the ETF tracking it is likely to fall too. Passive investors accept market returns, both positive and negative, rather than trying to avoid downturns or pick winners.
What is active investing?
Active investing is an approach where a fund manager or investment team makes decisions about what to buy, hold or sell.
The aim may be to outperform a benchmark, reduce risk, target income, avoid certain companies or capture specific opportunities. Active investing can be used in traditional funds, investment trusts and active ETFs.
Active ETFs combine the ETF structure with an active investment process. Instead of simply tracking an index, the manager has discretion to select investments. This can give investors access to professional decision-making in a fund that trades like an ETF.
The potential advantage is that a skilled manager may identify opportunities or manage risks differently from an index. The challenge is that active strategies do not always outperform, and they often come with higher costs.
The main differences between active and passive investing
The biggest difference is decision-making.
In passive investing, the index decides what the fund holds. If a company is in the index, the ETF will usually hold it. If the company grows and becomes a larger part of the index, it becomes a larger part of the ETF too.
In active investing, the manager decides. They may choose to avoid a company that looks expensive, increase exposure to a sector they believe is attractive, or hold more cash if the strategy allows it. This flexibility can be useful, but it also introduces management risk.
| Difference | Why it matters |
|---|---|
| Cost | Higher charges can reduce long-term returns |
| Transparency | Passive ETFs usually make the strategy easier to understand |
| Flexibility | Active managers can adjust holdings, while passive funds aim to follow the index |
| Performance | Passive funds aim to match the market; active funds aim to do something different |
| Risk | Both active and passive funds can perform better or worse than their benchmark |
When passive investing may appeal
Passive investing may appeal to investors who want a simple, low-cost way to access broad markets.
It can be an attractive option for investors who do not want to pick individual shares stay up to date with market news. A passive ETF can provide exposure to a market such as global equities, US equities, UK equities or bonds through one fund.
Passive investing may suit investors who value:
- Low costs
- Broad diversification
- Transparency
- Simplicity
- Long-term market exposure
Passive funds are often used as core portfolio holdings because they can provide broad exposure at relatively low cost.
When active investing may appeal
Active investing may appeal to investors who want a manager to make decisions rather than simply track an index.
This can be particularly relevant in markets where investors believe research, selection or risk management may add value. Active strategies may also appeal where an investor wants a specific outcome, such as income, quality exposure, lower volatility or a research-enhanced approach.
Active investing may suit investors who are comfortable with:
- Higher charges
- The risk of underperforming the benchmark
- Manager decision-making
- A strategy that may look different from the index
- Potentially greater variation in returns
Active funds should be judged over a suitable timeframe and against the right benchmark. Short-term performance alone is rarely enough to assess whether an active approach is working.
Active ETFs vs passive ETFs
Both active and passive ETFs trade on an exchange and can be bought and sold through an investment platform. The difference is how the investments inside the ETF are chosen.
A passive ETF tracks an index. An active ETF uses a manager-led process.
Active ETFs have grown in popularity because they combine some features investors like about ETFs, such as tradability and fund structure, with active portfolio management. Some active ETFs aim to outperform a benchmark, while others use a research-enhanced or rules-based approach.
Investors comparing active and passive ETFs should look at:
- The investment objective
- The benchmark
- The ongoing charge
- The holdings
- The manager or provider
- The risks
- How the ETF fits with the rest of the portfolio
Can investors use both active and passive funds?
Yes. Many investors use a blend of active and passive strategies.
One common approach is to use passive ETFs as the core of a portfolio, then add active ETFs for areas where the investor wants a more selective approach. For example, a portfolio might use a broad global ETF for core equity exposure and active ETFs for specific markets, factors or income strategies.
Using both does not guarantee better results. It can add complexity, and active funds can underperform. The benefit is that investors can combine low-cost market exposure with selected areas where they believe active management may add value.
The key is to avoid duplication. If an active ETF holds many of the same companies as a passive ETF, the portfolio may not be as diversified as it first appears.
Risks of active and passive investing
Both approaches carry risk.
- Market risk: investments can fall in value.
- Index risk: passive funds follow the index down as well as up.
- Manager risk: active managers can make decisions that underperform.
- Cost risk: higher charges can reduce returns over time.
- Concentration risk: both active and passive funds can become concentrated in certain companies, sectors or regions.
Investors should understand the strategy before investing and avoid choosing funds based only on recent performance.
How to invest in active and passive ETFs with InvestEngine
InvestEngine is a UK-based ETF investing platform, authorised and regulated by the Financial Conduct Authority, built for long-term investors who want to create DIY ETF portfolios.
With InvestEngine, you can buy and sell active and passive ETFs with 0% dealing fees and 0% platform fee on DIY portfolios. ETF costs apply.
You can invest through:
- A Stocks and Shares ISA
- A Self-Invested Personal Pension
- A General Investment Account
- A Business Investment Account
Investors can search for ETFs, compare fund details and build a DIY portfolio that matches their goals, timeframe and risk appetite.
FAQs about active vs passive investing
What is the difference between active and passive investing?
Passive investing aims to track an index. Active investing uses a manager or investment team to choose holdings and make decisions.
Is passive investing safer than active investing?
Not necessarily. Passive investing still carries market risk. If the index falls, the passive fund is likely to fall too.
Can active investing outperform passive investing?
It can, but it is not guaranteed. Active managers can outperform or underperform their benchmark.
Are active ETFs more expensive than passive ETFs?
They often are, because they involve manager research and decision-making. Investors should compare ongoing charges before investing.
Can I use active and passive ETFs together?
Yes. Some investors use passive ETFs as core holdings and active ETFs for selected areas of the portfolio.
Does InvestEngine charge dealing fees for active or passive ETFs?
InvestEngine charges 0% dealing fees for buying and selling ETFs. DIY portfolios also have 0% platform fees. ETF costs apply.
In summary
Passive investing aims to track the market, usually at low cost. Active investing aims to make decisions that may outperform, reduce risk or achieve a specific outcome.
Both approaches can play a role in an ETF portfolio. The important thing is to understand the strategy, compare costs, recognise the risks and make sure each ETF has a clear purpose.
Capital at risk. ETF costs apply. Tax treatment depends on your personal circumstances and may change in future. This communication is for general information only and does not constitute personal advice.