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An active fund manager at workMutual funds and exchange-traded funds (ETF) allow you to own a basket of securities, helping with portfolio diversification. When choosing which type of funds or ETFs to invest in, you may be wondering if active or passive management is better. Actively managed funds are overseen by a fund manager who’s responsible for deciding what the fund should own. These funds tend to carry higher expense ratios than passively managed funds but you get the benefit of the fund manager’s expertise. Here’s more on how actively managed funds work and their pros and cons.

Sometimes it’s wise to blend actively and passively managed funds in a portfolio, a strategy that a financial advisor can help you set up.

What Are Actively Managed Funds and How Do They Work?

Active management strategies rely on a single fund manager or group of fund managers making decisions about how to invest. For example, say an actively managed fund invests primarily in the tech sector. The fund manager or managers would choose which tech companies to buy or sell inside the fund. They may rely on market analysis and research, financial forecasting and their own years of experience to make those decisions.

The goal of actively managed funds is to deliver performance to investors that beats the market. This may mean outpacing the returns of a specific benchmark, such as the S&P 500 or the Nasdaq 100. As such, active fund managers are constantly tracking movements in the market to better navigate periods of volatility while generating the best returns possible.

Actively Managed Funds vs. Passively Managed Funds

Mutual fund manager at workPassive investing is the opposite of active management. With this type of strategy, the goal is not to meet the market but to match it. This is typically achieved by holding investments that track a specific stock market index. In terms of how actively managed funds compare to passively managed funds, there are some key differences, including:

  • Return potential. Actively managed funds may deliver higher returns than passive funds, depending on the fund manager’s skill and overall market conditions.
  • Cost. Passively managed funds may carry lower expense ratios than actively managed ones since the fund manager takes more of a hands-off approach.
  • Risk management. With actively managed funds, fund managers can more efficiently manage risk through the use of hedging strategies.

Are actively managed funds better than passively managed funds? There’s no definitive answer. Whether it’s better to invest in active vs. passive funds can depend on your risk tolerance, time frame for investing and investment goals. If you’re a long-term buy-and-hold investor, for instance, you may be fine with passively managed funds. But if you’re focused on performance, you may lean toward active management instead.

Pros of Actively Managed Funds

If you’re interested in actively managed funds or ETFs, it’s important to know what’s good (or bad) about them. On the pro side, there are several good reasons to consider an actively managed approach with mutual funds.

  • Outpace the market. Perhaps the most appealing reason to consider actively managed funds is their potential to beat the market. Depending on economic conditions and market trends, actively managed funds may be able to deliver returns that are well above the market average.
  • Professional expertise. Investing in the stock market can feel a little overwhelming if you’re just getting started. Actively managed funds can help with taking the guesswork out of deciding what to own in a portfolio since you’re relying on the fund manager’s experience, rather than your own.
  • Diversification. Investing in one or more actively managed funds can help with diversification. That’s important for managing risk and again, an active fund manager may be in a better position to hedge against potential volatility compared to funds that take a passive approach and simply track an index.

Cons of Actively Managed Funds

Like any other type of investment vehicle, active funds can have their downsides. Here are some of the most important things to watch out for with these funds.

  • Underperformance. While actively managed funds can outperform the market, that doesn’t guarantee that they will. An actively managed fund could underperform compared to the index it’s trying to beat, while a passive fund might hit its target return goals. In fact, many actively managed funds underperform their benchmark.
  • Turnover ratio. One thing to know about with mutual funds is how often assets turn over inside the fund. The more turnover occurs, the more capital gains tax you may have to pay each time a security is sold. Since actively managed funds tend to have higher turnover than passive funds, that could mean a bigger tax bite for you.
  • Management fees. As mentioned already, actively managed funds can come with higher expense ratios than passively managed funds. If you’re considering an actively managed fund with a high expense ratio, it’s important to weigh that against the fund’s historical performance to determine whether the cost is justified.

How to Invest in Actively Managed Funds

ETF managers at work

If you’re interested in adding actively managed funds to your portfolio, you can do so by opening an online brokerage account. When comparing brokerage accounts, be sure to pay attention to things like the minimum investment required, trading fees and the range of funds available. Some actively managed funds can have minimum investments of $5,000 or even $10,000, which may put them out of reach if you’re just getting started with investing.

In terms of how to choose which active funds to invest in, that takes a little more research. First, consider how much risk you’re comfortable taking on and what kind of returns you’re looking for. Next, think about what kind of diversification you’re hoping to add. For example, you may be looking for a fund that invests in healthcare or tech. And finally, think about what you’d prefer to pay for management fees.

As you look at individual funds, here’s a checklist of things to consider:

  • Fund makeup
  • Performance, including annual returns, compared to market returns
  • Fund manager’s background, experience and track record
  • Expense ratios and other fees
  • Fund turnover ratio

The fund’s prospectus should cover all of these things. You may also consider talking to your financial advisor as well about the potential tax implications of adding actively managed funds to your portfolio. Earning higher returns may lose some of its appeal if you’re handing back some of those earnings in taxes.

The Bottom Line

Active fund management can have its ups and downs and it may not be right for every investor. Understanding how an active strategy compares to passive investing can help you decide which one better aligns with your overall investment vision and goals.

Tips for Investing

  • Whether you’re considering getting started with investing or you’re already a seasoned investor, an investment calculator can help you figure out how to meet your goals. It can show you how your initial investment, frequency of contributions and risk tolerance can all affect how your money grows.
  • Consider talking to a financial advisor about active vs. passive investing to help decide which one is a better fit. If you don’t have a financial advisor yet, finding one doesn’t have to be complicated. SmartAsset’s financial advisor matching tool makes it easy to connect with professional advisors online. You can get personalized recommendations for advisors in your local area in minutes. If you’re ready, get started now.

Photo credit: ©iStock.com/FatCamera, ©iStock.com/GlobalStock, ©iStock.com/GlobalStock

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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