Active vs. Passive Investing: Which is Right For You?

After you’ve chosen a great online broker, added some money to your account, and decided your own risk tolerance, the next step is typically to decide between an active vs. passive investing approach.

As you’ll quickly find out, the active vs. passive debate can feel as polarized as politics, with some financial experts swearing you need to buy shares in active mutual funds and others telling you to put your money in index funds that simply follow the market’s ups and downs. 

So, as a beginner investor, or someone with a little experience under their belt, which approach is right for you? Let’s take a closer look at the passive vs. active debate and see. 

What is the difference between active and passive investing?

First off, when you hear people talking about active vs. passive investing, they’re typically referring to how investment funds, such as mutual funds or index funds, are managed. Recall that a fund is simply a basket of investments (usually stocks, but also bonds). When you buy a share in a fund, you instantly diversify your portfolio, as a fund holds numerous stocks. 

Active investing

When a fund is actively managed, the fund manager is trying to outperform an index market, such as the TSX. These fund managers are nearly always financial experts who have the credentials and qualifications to choose a fund’s stocks.

The promise of an actively managed fund is that over time your portfolio will have a higher return on investment (ROI) than the index market itself. Most mutual funds involve an active investing management. 

Passive investing

A passively managed fund, on the other hand, doesn’t try to beat the market. Managers of passive funds, such as index funds or exchange-traded funds (ETFs), simply want to match the performance of a specific index. For this reason, passive funds can mirror the ROI of the index markets they follow, but they’ll never surpass it. 

Because passively managed funds follow the ups and downs of the market, they typically require far less human oversight. Most are automated, which helps keep the costs of passively managed funds fairly low. Active funds, on the other hand, require far more work on the part of the fund manager, which is why their fees are higher.  

Do active funds outperform passive funds?

You’d think actively managed funds would almost always outperform passive ones, right? After all, an active fund manager can react quickly to market downturns, sell shares of bullish stocks before they turn bearish, and find undervalued stocks faster than a robot. How could you beat that? 

In reality, active fund managers rarely outperform passive funds over the long-term. It’s not hard to imagine why. Picking stocks that beat the market, not just once, but numerous times, is extremely hard to do. Even if you have a great fund manager, there’s absolutely no guarantee that their choices will have a higher ROI than the market itself. 

Aside from human error, there’s another reason passive funds typically outperform active ones over the long-term: fees. Actively managed funds simply cost more than their passive counterparts. The management expense ratios on active funds can cost on average 1.38% more than passive funds.(1) When you’re trying to beat the market, that 1.38% can easily drag you down. 

For this reason, many Canadians are starting to follow the world trend of choosing passive vs. active investing. Passive funds don’t beat the markets they follow, sure. But, over the long term, their ROI mirrors its performance. The fees are lower, ensuring you get the full benefit of your returns. 

What are the pros and cons of active investing?

Active investing involves fund managers and their teams actively researching, analyzing, and picking stocks with the goal of outperforming the market. While this approach can lead to impressive gains, it also carries higher costs and no guaranteed success.

Pros of active investing

• Expert management: Active fund managers work with teams of financial analysts who conduct in-depth research to identify strong investment opportunities.
• Potential for market-beating returns: When fund managers make the right calls, you could see higher-than-average returns, especially in volatile or inefficient markets.
• Flexibility: Active managers can quickly adjust portfolios in response to market conditions, which can be advantageous during market downturns or economic shifts.

Cons of active investing

• No guaranteed outperformance: Even experienced managers can underperform the market; long-term, very few consistently beat market averages.
• High fees: Active funds typically charge higher management expense ratios (MERs), which eat into your returns. The fund has to not only outperform the market but also earn enough to cover these fees.
• Disappointing returns possible: You might earn lower returns than a passive index fund, especially after fees are deducted.

Active investing can pay off if you choose a skilled manager capable of consistently identifying winning investments. However, it’s not a guaranteed path to higher returns, and over time, many active funds fail to outperform the market after fees.

What are the pros and cons of passive investing?

Passive investing involves tracking a market index rather than trying to beat it. This approach is known for its low costs and consistent market-mirroring performance, but it also means accepting both market ups and downs.

Pros of passive investing

• Lower management fees (MERs): Passive funds charge significantly less than active funds.
  • Average MERs in Canada: ~0.28% for passive funds vs 1.59% for active funds (a 1.31% difference).
  • Example: If you invest $10,000 in each:
    • Passive fund fee: ~$29.40 (on a $10,500 balance after a 5% gain).
    • Active fund fee: ~$166.95 for the same gain—over 5x higher than the passive fund.
• Market-mirroring performance: Passive funds follow the performance of the overall market or index, which historically trends upward over the long term.
• Long-term growth potential: If the index you track grows steadily, your investment can compound significantly over time with minimal management effort.

Cons of passive investing

• No chance to beat the market: Passive funds are designed to match, not outperform, the market’s returns.
• Market downturn exposure: When the market drops, your investment value will drop too, since it mirrors the index.

Passive investing is a cost-effective, long-term strategy that works best for investors who are comfortable riding out short-term market fluctuations. While you won’t outperform the market, you’ll keep more of your gains by paying much lower fees than with active investing.

Active vs. passive investing: which is better for you? 

If you don’t have time to research your own stocks, or you are just starting to invest, a passive investing approach may be right for you. You won’t pay high MERs, and you can rest assured that your investments aren’t straggling far behind the market. On top of that, passive funds give you instant exposure to a wide variety of companies within a specific sector or industry, helping you diversify your portfolio at a fairly low cost. 

Of course, you don’t have to choose a side in the passive vs. active investing debate. You can buy shares of both. In fact, many investors have been successful at combining passive and active investing strategies. In this way, a passive fund can give you greater security, while an active fund can put a little edge on your investment portfolio. 

Before you choose an active fund, be sure you do your research first. Some active funds cost far less in MERs, while others will have fund managers with a proven track record of outperforming the market.

The goal is to find an active fund manager who has consistently outperformed the market over a long period of time, while also doesn’t charge higher MERs than their peers. Combine that with a passive fund that follows a strong market index and you could have a well-diversified portfolio on your hands.