ETFs are most often associated with passive index-tracking strategies, but they have a role to play for active investors trying to beat the market, too.

In recent years, the term passive investing has gained popularity to describe the use of low-cost index-tracking funds that aim to closely replicate the returns of a particular market. This approach differs from active investing, which typically involves attempting to outperform the market.

Active investing involves investing in funds managed by professionals who aim to select stocks that perform better than the market average or time the market effectively by moving in and out of different assets.

Some private investors choose to pick stocks for themselves, which is also considered active investing.

Passive

Before the invention of tracker funds, investing was typically done actively, even if the goal was to achieve market returns. Investors would often buy a basket of large, well-established stocks or invest in actively managed funds that aimed to do the same.

In the 1970s, the concept of index funds emerged as a result of academic research that showed most active fund managers were unable to consistently beat the market. Index funds used mechanical rules to construct portfolios that tracked market indices, and they were significantly less expensive than actively managed funds.

Today, exchange-traded funds (ETFs) are the most popular type of index fund. ETFs are traded like stocks through brokerage accounts, and they cover all major markets and asset classes, making it possible for anyone to construct a low-cost, diversified, passive portfolio.

Passive Beats Active 

Passive investing may initially seem like a lackluster approach to investing. After all, why settle for average returns when you could pay a little extra for a skilled manager who outperforms the market? However, research shows that most active managers do not actually beat the market, and their fees often eat into any potential gains. In contrast, passive investors who simply track an index can achieve higher returns at a lower cost.

Studies have shown that the majority of active funds lag behind their benchmarks over the long term. For instance, a survey by financial firm Vanguard found that 70% of active funds available to UK investors underperformed their benchmarks over a 10-year period. Other research has reported similar findings.

Moreover, even successful fund managers' market-beating streaks tend not to last, which means investing in recent top-performing funds is not a guarantee of future success.

In addition to potentially higher returns, passive investing can also help avoid common investment pitfalls. Private investors often make the mistake of chasing hot performers, buying funds when they're popular and selling them when they're cheap and out of fashion. A passive strategy based on asset allocation and regular savings can help counteract these harmful tendencies.

Active Investing and ETFs

While passive investing may be the most appropriate choice for most investors, some people may still wish to take a more active approach. ETFs offer several ways to do so, including sector rotation, theme-based investing, tactical allocation, and short-term trading. Sector rotation involves trading in and out of different sector ETFs in an attempt to exploit the economic cycle. Theme-based investing involves purchasing an ETF that tracks stocks in a particular area or sector that you believe will outperform in the future. Tactical allocation involves overweighing cheaper or more promising countries or assets while under weighting more expensive ones. For those interested in testing their trading skills, buying and selling ETFs may be cheaper than trading individual shares and may provide better liquidity.