Whether a passively or actively managed mutual fund is better for you depends entirely on your investment goals and risk tolerance. Both management styles have advantages and drawbacks, but if you choose a fund with a manager whose investment style does not align with your own, you are likely to end up very disappointed.

Passive Fund Management: The Basics

A passive investment strategy is one that seeks to mimic the assets and returns of a specific benchmark, such as the S&P 500. Index funds are a popular type of passively managed fund. Index funds simply invest in all the same securities as the index they follow. An index fund based on the S&P 500, therefore, owns all the stocks listed on that index. The goal is not to outperform the market but rather to achieve the same returns as the index. If the value of the S&P 500 increases by 5%, the fund also gains about 5%. If the value of the index declines, the value of the fund drops by approximately the same amount.

A passive management style is not just restricted to stock funds. Bond funds are often passively managed. In this type of fund, the manager may purchase a variety of long-term bonds from governments or highly rated corporations and simply hold them until maturity. Risk to shareholder principal is minimal due to the stability of these types of bonds. In addition, the portfolio generates consistent annual income for shareholders as a result of the bonds' coupon payments.

Are Passive Funds Right for You?

Passively managed funds are great for those who are looking for low-risk investment and are not overly concerned with seeing rapid gains. The growth of passively managed funds stems from the long-term increase in the value of their assets or from dividend or interest payments, not profit generated by frequent buying and selling of securities. The assumption is the market is efficient and generates returns over time.

Because of the minimal number of trades executed each year, index and other passively managed funds tend to have lower expense ratios. This makes them a good fit for those who are wary of paying fees each year without any real assurance of profit in the future.

However, when it comes to index funds, remember the fund mimics the index in good times and bad. Your risk of loss may actually be quite high with a passive fund in a bear market because the fund matches the losses experienced by the index rather than trying to mitigate loss by altering its portfolio.

Actively Managed Funds: The Basics

Conversely, actively managed funds are geared toward outperforming common benchmarks. Instead of simply investing in the same holdings as an index, active fund managers spend countless hours analyzing different securities to determine which are most profitable. They alter the composition of their portfolios to include different asset classes, sectors or specific securities based on what their research indicates the relative profitability of each option.

An active fund manager pays attention to upcoming earnings reports, dividend announcements, political events and product launches to take advantage of temporary spikes or drops in stock prices. The announcement of a new iPhone, for example, might lead an active fund manager to shift his fund's portfolio to a more substantial investment in Apple leading up to the release date to take advantage of the upswing such product releases generally prompt.

Like passive management, active management can be applied to a variety of mutual funds. Many high-yield bond funds are actively managed. Rather than waiting for bonds to mature and relying on coupon payments to provide regular income, active bond fund managers buy and sell bonds frequently to capitalize on fluctuating prices in the bond market.

Are Active Funds a Better Choice?

Due to their volatile nature, actively managed funds are better suited for investors who do not mind a decent amount of risk. The trade-off, of course, is that actively managed funds often provide greater opportunity for profit than their more stable passively managed counterparts.

The frequent trade activity inherent in active funds poses a greater threat to shareholder capital, as does the volatility of individual securities within the portfolio. Many active funds are focused on generating big gains relatively quickly, which means they invest heavily in volatile stocks and low-rated bonds. Volatility in the stock market increases the odds of both profit and loss, while junk bonds provide the opportunity for capital gains but have a high risk of default. Thus, actively managed funds are best for those who have a little wiggle room in their finances and do not mind taking on a fair amount of risk in exchange for the possibility of big gains. However, bear in mind the increased expenses incurred by active management may eat up a significant portion of profits.