The Pros and Cons of Active Investing vs Passive Index Funds

From an early age, we’re taught that being active is better than being passive. “Don’t just sit there—do something!” And that makes sense in most areas of life, like taking care of your health, advancing your career, or improving your golf game. In those cases, passivity rarely gets you far.

So it might come as a surprise that when it comes to investing, sometimes being passive can actually lead to better results. The debate over active versus passive investing has been around for decades, with good points on both sides. Here’s what each approach means, how they differ, and why at Gold Medal Waters, we believe the best strategy combines the strengths of both.

The Basics: Active vs. Passive Investing

You’ve probably heard these terms before.

Active investing means trying to beat the market. Fund managers analyze data, research companies, and make decisions about which stocks or bonds to buy and sell. The goal is to earn a higher return than a market benchmark such as the S&P 500.

Passive investing aims to match the market. The goal is track a specific index, such as the S & P 500 or a European stock index, and hold the same securities in the same proportions. Passive index funds are designed to deliver the return produced by a specific market, minus the fund’s fees – no more, no less. 

The key difference between active and passive investing is the role that portfolio managers or analysts play. In passive investing, the market dictates the securities that are held and the weight that is assigned to each security. In active investing, these decisions are made by people.

Active Investing Does Things Passive Investing Cannot, and Vice Versa

Both styles have strengths, and each comes with trade-offs. 

• Active strategies try to outperform the market. Managers of these strategies use their knowledge and proprietary analyses to select securities that they believe have the best potential and give them whatever weightings they think makes sense. For example, a stock that is 0.1% of the total value of the S&P 500 could represent 5% of an active strategy. Passive investment strategies do not try to outperform a market. Their goal is to deliver the return on a benchmark or index that captures a chosen market or market segment, minus fees. It doesn’t “choose” securities or their weights, those are determined by the index the strategy tracks. A passive strategy should not do any worse than the market its index represents but makes no attempt to do any better. If it does, something is off.
  

• Active strategies seek to protect investors by avoiding positions their analyses do not favor. This might include proactively reducing exposures to stocks or entire sectors that have performed well and could be at risk of a pull-back, in other words, “taking money off the table” after a good run. Since passive investment strategies are on autopilot, they have no point of view and take no action regardless of what happens. Whether a stock doubles in value or is cut in half, the passive strategy continues to hold it. The relative weightings across the holdings adjust automatically as prices move around. Positions stay the same, except for relative weights, until an index “rebalances” (usually once or twice a year), and new positions are added while others are dropped to stay true to the index rules.
  

• Active strategies use research and analyses to gain early insights that benefit their investors before the market recognizes what the strategy has uncovered. Passive strategies rely on the market dictating what a stock is worth. Passive strategies do not reflect deep dive research that uncovers a company’s competitive situation, potential to deliver a breakthrough product, or financial condition.
  

Active investing’s strengths are also its weaknesses. Same with passive investing.

Active investing

• Seeks to outperform the market through research, analysis, and strategic decision-making

• Can potentially avoid trouble spots by reducing exposure to overvalued sectors or taking profits after a good run

• Uses human insight to identify opportunities that the broader market might overlook

But those same strengths can also be weaknesses:

• Skilled managers and research teams cost money, which means higher fees.

• Key managers may leave and replacements may not be able to replicate their performance

• Active funds often trade more, which can lead to higher taxes.

• It is rare to find an active fund that consistently outperforms the benchmark over time.

Passive investing

• Is simple, low-cost, and transparent

• Doesn’t depend on a manager’s judgement, so it avoids the risk of poor decisions or emotional reactions

• Almost always delivers the same return as the market it tracks (minus a small fee)

But:

• It’s fully on autopilot. Passive strategies don’t react when markets shift, even if a stock becomes overvalued or risky.

• Passive indexes automatically give the biggest weight to the largest companies, so investors may end up with a heavy concentration in just a few names.

Instead of having to choose one or the other, can we combine active and passive?

Passive investing appeals to us because it’s efficient, disciplined, and cost-effective. But we also believe there’s room for intelligent adjustments, especially when data and research can help identify factors that drive higher returns over time.

Gold Medal Waters has turned to investment firms that offer funds that incorporate a systematic, rules-based process to build portfolios. Like passive investing, such funds eliminate the emotional, day-to-day decision-making that can derail performance. But unlike traditional index funds, they take factors into account such as  company profitability, valuation, and size.

This “factor-based” approach has deep roots in academic research and economic theory (including work from several Nobel Prize winning economists). It tilts portfolios toward areas of the market that have historically offered higher expected returns, without relying on guesswork or market timing.

Our Take

At Gold Medal Waters, we believe investors shouldn’t have to choose between active and passive. By tilting toward funds that incorporate a systematic, rules-based selection process, our clients benefit from the discipline, diversification, and low costs of passive investing, while also taking advantage of the data-driven insights and flexibility found in active strategies. While we may not put the “active versus passive” debate to rest,  our clients have increased confidence that their money is invested wisely, based on a discipline that recognizes both sides.