Sorting through thousands of mutual funds to find the ones most appropriate for you can be a daunting challenge. Beyond the types of investments they hold, mutual funds also can be categorized based on their fund manager’s investment style – active management or passive management.

In general terms, active management refers to mutual funds that are actively managed by a portfolio manager. Passive management typically refers to funds that simply mirror the composition and performance of a specific index, such as the Standard & Poor’s 500^® Index.

Actively managed funds

With actively managed funds, managers decide to buy or sell securities based on their expectations for how those securities will perform. Typically, an actively managed fund will seek to outperform a designated index or benchmark that aligns with its investment mandate—for example, the S&P 500 Index, is used for a large-cap stock fund. (The S&P 500 Index is a market-cap-weighted index that represents the average performance of a group of 500 large capitalization stocks.)

How active management works

Active management takes a hands-on approach. Rather than following preset rules to build a portfolio of stocks or bonds, managers of actively managed mutual funds make buy and sell decisions, selecting individual stocks and bonds according to a rigorous methodology and thorough company research.

Why active management

• When you invest in these funds, you’re benefiting from the years of experience across a wide range of market conditions that fund managers provide.
• Investors who prefer funds with active management believe this more human approach provides a real financial value that passively buying the market (or a segment of the market) based on an automated model, cannot.
• Active fund managers have a host of resources to help them track and respond to the market’s ups and downs as well as positive or negative changes to individual company’s fundamentals.
• When you invest in an actively managed fund, you’re tapping into the collective expertise of the fund managers and their teams who understand the factors that can impact individual companies and the market as a whole.

Often, teams of analysts and experts help identify investing opportunities, make buy and sell decisions, and manage the fund on a daily basis. These teams work to maintain the right mix of investments which they believe will achieve each fund’s specific goals for performance and risk.

Decisions are supported by financial analysis and modeling tools that help forecast possible market performance. This combination of human know-how, sophisticated tools, and seasoned fund managers delivers rigor and discipline that makes active management so attractive to many investors. Of course, all this research and analysis costs money, which usually leads to actively managed funds having higher expense ratios than passively managed funds.

Passively managed funds

Known also as “index funds” – passively managed funds do not attempt to outperform a designated index. Rather, they simply seek to mirror the performance of an index by holding the same or similar securities in the same proportions. The managers only buy or sell securities as necessary to correspond with the index.

How passive management works

A typical passively managed fund might contain all stocks in a particular index like the S&P 500 index, a market-cap-weighted index that represents the average performance of a group of 500 large capitalization stocks.  When the S&P 500 index rises and falls, so does the passive fund, often by similar amounts. When individual stocks move in or out of the S&P 500 index, the fund buys and sells the same stocks. For passive funds that mirror indexes like the S&P 500 index, this is sometimes referred to as “buying the market.” This buying and selling incurs management and other expenses, thus performance for these funds may vary from that of the index itself. 

Why passive management

• Trades within the portfolio are automated, with little or no human decision-making involved.
• It’s a simple and straightforward investing approach that makes these funds a popular choice for some investors.
• Expense ratios of actively managed funds, which require ongoing analysis and portfolio management, are typically higher than passively managed funds.

There’s no right or wrong answer to whether you should invest in active or passive mutual funds. Whatever you decide, make sure to do your research and consider all of your options.