If you look up active and passive on the internet, you will come up with various uses of these terms. The terms are used in English grammar to describe sentence construction, to describe different ways that people can choose to live their life and the terms are used to categorize investment fund management styles. In this article we will focus on active and passive investment, covering what they both are, and factors to consider when choosing the investment approach that is right for you.

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Active fund management involves analysts selecting the assets that their fund will hold, and they do so in return for a fee. The first funds were actively managed, and together they account for the vast majority of collective investment opportunities – probably more than 90% of the options.

Passive management differs in that the fund’s investment decisions are not made by people, but are determined by a rule, normally by following an index that is being tracked. The decisions to buy and sell flow automatically from rules designed to keep the fund’s investment allocation in line with the index being tracked.

There are two main forms of passive fund management: index tracking and exchange traded funds (ETF’s). Index trackers began in the 1970’s while ETF’s were first traded in 1993. Index trackers and ETF’s differ in various ways, but is difficult to make generalizations as large index trackers may share many of the characteristics of large ETF’s. Material differences to look out for when considering an ETF or index-tracker include the annual charges, the bid-offer spread (in the case of ETF’s), the degree to which the index is replicated and the tax implications of the dividend payment strategy of the candidates you are considering. ETF’s have been one of the fastest growing forms of investment in recent years due to their low costs and ease of access, and this has led to a proliferation in the number of funds and indices being tracked and asset classes available.

Passive fund management is in theory much easier to implement. If a fund is following a particular index, then the fund manager would purchase shares in the same proportion to the index. For example, if the index being tracked was the S&P 500, then the fund manager would purchase shares in the index’s 500 constituent companies, and change it as needed.

In reality, some trackers do not invest in all the constituents – in other words they do not copy the index exactly – but follow their own approximation. This can lead to small divergence between the index and the fund, but the divergence is done for pragmatic reasons rather than as a reflection of any investment outlook. With no manual judgement involved, passive fund management can be automated and implemented cheaply by a computer able to manage the fund without much costly human interaction. Passive investing has lower stock turnover which is passed on in the form of lower expense ratios – great characteristics for the buy-and-hold investor.

Active management involves higher costs and thus higher fees. The fund managers need to be paid to research the available stocks, to trade and to modify their positions. Active funds have far higher stock turnover rates than passive funds, and these costs are also passed on to the investor through fund charges.

There is plenty of finance theory that shows that an investor can get better risk adjusted returns by diversifying their investment strategy. In effect this means not putting all your eggs in one basket. Fund managers provide this service, and charge a cost for managing the basket of investments. Active fund management costs more than passive fund management, and this is reflected in the fees charged.

Nassim Taleb (the author of Fooled by Randomness and Black Swan) and many others have argued that actively managed funds – on average – can’t beat the index they are tracking (net of charges). Due to the large numbers of funds, some will beat the index, although rigorous analysis taking into account things like “survivorship bias” shows that the winners are likely to be winning due to chance, and in the longer term, very few active funds will beat the index consistently and the probability of selecting them is low.

Warren Buffett, when quizzed on personal finance has repeatedly advocates passive funds with low charges. While there may be a wider range of active funds to choose from, there is mounting evidence pointing towards passive funds being better for the long term. We can live our lives actively or passively. If investment experts like Warren Buffett advocate passive management, should we actively follow their advice?

Greg Becker is the founder of GetGuidance.com, an actuary and social entrepreneur hoping to help people get comfortable making important decisions, and to then make better choices. He is an avid cyclist and has lived and worked in North America, Africa, Asia and Europe.

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