The debate between passive and active investing is often presented as settled: passive wins. This framing is too simple. While evidence strongly favours passive approaches in many contexts, the choice involves genuine trade-offs that depend on individual circumstances.
This article explains what passive and active investing actually mean, examines the key dimensions where they differ (cost, effort, tracking error, behaviour, and consistency), and discusses how to think about which approach might fit different investors. It avoids the temptation to declare a universal winner.
This is general educational information, not personal financial advice.
What the Terms Mean#
Passive investing aims to match the returns of a market index, such as the ASX 200 or a global shares index. The investor accepts the market's return, minus costs, without trying to beat it. Index funds and most exchange-traded funds (ETFs) follow this approach.
Active investing aims to beat the market through selection, timing, or both. Active managers choose which securities to hold, when to buy and sell, and how to weight different positions. The goal is to outperform the index, not just match it.
The distinction is not always clean. Some funds marketed as passive make active decisions about which index to track or how to weight holdings. Some active funds stay close to their benchmark, making only modest deviations. But the core difference remains: passive accepts the market return; active tries to exceed it.
Cost: The Most Reliable Difference#
The clearest difference between passive and active is cost.
Passive funds typically have low management fees because they do not require expensive research teams, analysts, or portfolio managers making daily decisions. A broad market index fund might charge 0.1% to 0.3% per year. An active fund might charge 0.8% to 1.5% or more.
This difference compounds over time. A 1% annual fee difference on a $100,000 portfolio, assuming 7% gross returns, results in approximately $50,000 less wealth over 30 years. The active fund would need to outperform by at least 1% per year just to match the passive fund's net returns.
Beyond stated fees, there are hidden costs. Active funds trade more frequently, incurring transaction costs and potentially triggering taxable events. Passive funds also have implementation costs, particularly during index reconstitutions when they must buy or sell securities to match index changes.¹ But these tend to be smaller and less frequent than the trading costs of active management.
Cost is not the only consideration, but it is the most predictable one. Future performance is uncertain. Fees are known in advance.
Effort and Complexity#
Passive investing is simpler. Choose an index (or a few), select a low-cost fund that tracks it, contribute regularly, rebalance occasionally. The process requires minimal ongoing decisions.
Active investing, whether done personally or through active funds, requires more effort. If selecting individual securities, the investor must research companies, monitor positions, and make ongoing buy and sell decisions. If selecting active funds, the investor must evaluate managers, monitor their performance, and decide when to stay or switch.
This effort is not inherently bad. Some investors enjoy the process. But effort does not guarantee results. The evidence consistently shows that the average active investor, whether professional or amateur, underperforms the market after costs.² The time spent selecting stocks or funds often produces negative value.
For investors who want simplicity and do not derive satisfaction from active decision-making, passive approaches remove a significant source of complexity and potential error.
Tracking Error: Accepting the Market vs Deviating from It#
Tracking error measures how closely a portfolio follows its benchmark. Passive funds aim for minimal tracking error: they want to match the index as closely as possible.
Active funds accept higher tracking error as the price of seeking outperformance. If a manager believes certain sectors or stocks will do better than others, they overweight those positions. This deviation creates the potential for both outperformance and underperformance.
For passive investors, low tracking error provides predictability. You know roughly what you will get: the market's return, minus costs. There are no surprises, good or bad.
For active investors, tracking error creates uncertainty. In some periods, deviations pay off and the portfolio beats the market. In other periods, deviations fail and the portfolio lags. The variance is higher in both directions.
The question is whether the investor can tolerate this variance and whether they have reason to believe the deviations will, on average, add value. For most investors, the answer to the second question is no.
Behaviour: Where Many Returns Are Lost#
One of the most underappreciated factors in the passive vs active debate is behaviour.
Active investing creates more opportunities for behavioural errors. Every decision point is a chance to make a mistake: buying high because something has been rising, selling low because something has been falling, chasing last year's winners, abandoning strategies during temporary underperformance.
Research on individual investor behaviour consistently shows that these errors are costly. Investors who trade more frequently tend to earn lower returns.³ Investors who try to time the market tend to underperform those who stay invested. The gap between fund returns and investor returns (the behaviour gap) is often larger than the gap between active and passive fund returns.
Passive investing reduces decision points. There is less to decide, so there are fewer opportunities to make harmful decisions. This does not eliminate behavioural errors (investors can still panic sell an index fund), but it reduces their frequency.
For investors who know they are prone to second-guessing, overtrading, or reacting emotionally to market movements, the reduced complexity of passive investing is itself a form of risk management.
Consistency and Persistence#
One of the strongest arguments for passive investing is the lack of persistence in active manager outperformance.
Studies consistently show that past performance does not reliably predict future performance for active managers.⁴ A manager who outperformed over the past five years is not significantly more likely to outperform over the next five years. The winners rotate, and identifying them in advance is extremely difficult.
The Morningstar Active/Passive Barometer, which tracks thousands of funds over time, found that over a recent ten-year period, only about 8% of large-cap active funds in the US outperformed their passive counterparts.⁵ The odds improve slightly in some categories (small-cap, emerging markets) where markets may be less efficient, but even there, the majority of active funds underperform.
This does not mean all active managers are unskilled. Some do add value. The problem is identifying them in advance. After the fact, it is easy to see who won. Before the fact, it is nearly impossible.
For investors without a reliable method for selecting superior active managers, passive investing offers a more consistent outcome: the market's return, whatever that turns out to be.
Where Active Might Make Sense#
The evidence favours passive in most broad equity categories, particularly large-cap developed markets. But there are contexts where active approaches may have more room to add value:
Less efficient markets. In emerging markets, small-cap stocks, or specialised sectors where information is less widely available and prices may not fully reflect fundamentals, skilled active managers may have more opportunity to outperform.
Specific mandates. Some investors have constraints (ethical screens, tax considerations, concentration limits) that require active management or at least active deviation from standard indices.
Access to exceptional managers. A small number of active managers do outperform persistently. If an investor has access to such a manager (and can verify the track record is genuine), active management may be appropriate. This is rare and difficult to evaluate.
Personal engagement. Some investors derive satisfaction from the process of active investing, and that engagement keeps them invested through difficult periods. If active involvement prevents panic selling during downturns, the behavioural benefit may outweigh the cost disadvantage.
These are exceptions, not the rule. For most investors, in most contexts, passive remains the more reliable choice.
The Case for Humility#
The passive vs active debate sometimes becomes ideological. Passive advocates insist active is always wrong. Active advocates insist passive is lazy or naive.
Both positions miss the point. The real question is not which approach is philosophically correct but which approach is likely to serve a particular investor's goals, given their circumstances, temperament, and resources.
For most retail investors, the evidence points toward passive:
- Lower costs
- Less complexity
- Fewer decision points
- More predictable outcomes
- No need to identify outperforming managers
But the evidence does not say passive is perfect or that active is impossible. It says the odds favour passive, especially after costs and behavioural errors are accounted for.
Investors who choose active should do so with open eyes: understanding that they are more likely to underperform than outperform, that the effort involved may not pay off, and that the decision requires ongoing discipline to avoid compounding errors.
Summary#
Passive investing aims to match market returns at low cost; active investing aims to beat the market through selection and timing. The key trade-offs involve cost (passive is cheaper and the difference compounds), effort (active requires more decisions and research), tracking error (passive is predictable; active introduces variance), behaviour (more decision points create more opportunities for error), and consistency (active outperformance is rare and difficult to predict in advance). Passive approaches are favoured by evidence in most broad equity categories, but active may have a role in less efficient markets, for specific mandates, or for investors with verified access to exceptional managers. The choice depends on individual circumstances, not ideology. Most investors are well-served by low-cost, diversified, passive strategies, with the understanding that "average" market returns, compounded over time, produce outcomes that most active strategies fail to match.
Sources#
- Tasitsiomi, A. (2025). On the hidden costs of passive investing. arXiv preprint. https://arxiv.org/abs/2506.21775
- Barber, B. M., & Odean, T. (2000). Trading is hazardous to your wealth: The common stock investment performance of individual investors. The Journal of Finance, 55(2), 773-806. https://doi.org/10.1111/0022-1082.00226
- Barber, B. M., & Odean, T. (2013). The behavior of individual investors. Handbook of the Economics of Finance, 2, 1533-1570.
- Carhart, M. M. (1997). On persistence in mutual fund performance. The Journal of Finance, 52(1), 57-82. https://doi.org/10.1111/j.1540-6261.1997.tb03808.x
- Morningstar. (2025). Active/Passive Barometer. https://www.morningstar.com/lp/active-passive-barometer