What is the difference between active and passive investing?

Passive investing means holding a whole market through an index fund or ETF and accepting its return, minus low costs. Active investing means selecting investments — individual stocks, sectors, the timing of purchases — with the aim of doing better than the market. Active investing is what fund managers do, and what private investors do when they pick their own stocks.

The arithmetic of active management

The economist William F. Sharpe pointed out a simple identity in 1991. Before costs, the return of all investors together is the market's return. It is made up of what passive and active investors earn, in proportion to their shares $w$ of the market:

R_{\text{market}} = w_{\text{passive}} \, R_{\text{passive}} + w_{\text{active}} \, R_{\text{active}}

Passive investors earn exactly the market's return, so active investors as a group must earn the market's return too — before costs. After costs, which are higher for active investing, the average actively invested euro must do worse than the average passive one. Some active investors beat the market, but only at the expense of others who lag it.

A simple illustration

The market returns 7% a year before costs. A passive fund costs 0.2% a year; the average active fund costs 1.5%, including trading:

R_{\text{passive}} = 7\% - 0.2\% = 6.8\% \qquad R_{\text{active}} = 7\% - 1.5\% = 5.5\%

Over 25 years, €10,000 grows to about €51,800 in the passive fund and about €38,100 in the average active fund.

What the evidence shows

Long-running comparisons such as the SPIVA reports consistently find that most actively managed equity funds lag their benchmarks over ten years or more, and that past outperformance is a weak guide to future outperformance. The pattern holds across regions and asset classes, with some variation between them.

Arguments for active investing

Some markets are less efficient, such as small companies or some emerging markets, where information is scarcer.
Specific goals — income, sustainability criteria, lower volatility — can justify deviating from the index.
Interest and learning. Many private investors enjoy selecting stocks and accept the likely cost.

Combining the two

A common approach is core-satellite: a large, low-cost passive core, for example a world ETF, with a smaller active part for individual ideas. It keeps the portfolio's result close to the market's while leaving room for active choices — and comparing the satellites with the core shows what those choices have actually added or cost.

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