Index Funds vs. Actively-Managed Funds

Index Funds Are Smart for Long-Term Investors

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The index funds vs actively-managed funds debate is a smart one for every investor to engage in. Each type of mutual fund has its advantages and disadvantages. However, the best funds to buy will depend upon the individual investor's personal circumstances and investment objectives. Here's what to know about index funds vs actively-managed funds.

What Is an Index Fund?

Index funds are considered to be passively managed. The manager of an index fund tries to mimic the returns of the index it follows by purchasing all (or almost all) of the holdings in the index. Hundreds of market indexes can be invested in via mutual funds and exchange-traded funds.

What Is an Actively-Managed Fund?

The portfolio manager of an actively-managed fund tries to beat the market by picking and choosing investments. The manager performs an in-depth analysis of many investments in an attempt to outperform the market index, like the S&P 500.

Should You Own Index Funds or Actively-Managed Funds?

The potential to outperform the market is one advantage that actively-managed funds have over index funds, and this notion of outperformance is attractive to investors. After all, why settle for an index fund when you know you will only receive the market return, less a nominal fee, to the fund’s manager?

Unfortunately, evidence that actively-managed funds can consistently outperform their relevant index is difficult to find. It’s even more challenging for an individual investor to identify which actively-managed fund will outperform the index in a given year.

According to Vanguard, in a study of index funds vs active funds, for the 10-year period ended December 31, 2018, 9 of 9 Vanguard money market funds, 41 of 60 Vanguard bond funds, 20 of 23 Vanguard balanced funds, and 129 of 146 Vanguard stock funds—for a total of 199 of 238 Vanguard funds—outperformed their peer-group averages. Keep in mind, however, that most, not all, of Vanguard funds are index funds. Still, these results show the long-term advantage of passive investing vs active investing.

Active Management: Luck or Skill?

You might point out that some funds indeed beat their indexes, so why not buy those? Well, how do we know whether the active manager was skilled in his or her investment selection, or was just lucky? The evidence from a Barclays Global Investors study shows that the chance is slim for continued out-performance by an active manager to continue beating the index.

Index Funds vs Active Funds: Cost

Actively-managed funds start at a disadvantage when compared to index funds. The average ongoing management expense of an actively-managed fund costs 1% more than its passively managed cousin. The expense issue is one reason why actively-managed funds underperform their index.

Index Funds vs Active Funds: Tax-Efficiency

Another issue, which is not reflected in fund return numbers, is that the portfolio manager of an actively-managed fund -- who is in search of extra returns -- buys and sells investments more frequently than an index fund. This buying and selling of stocks by the active manager -- known as turnover, results in taxable capital gains to the fund shareholders, provided the fund is owned in a non-retirement account.

Bottom Line

As with many investment decisions, the best type of funds to buy depends on the individual's personal circumstances and financial objectives. While history shows that there are good active managers, finding such managers in advance of their out-performance is difficult. Since index funds have historically beaten the majority actively-managed funds for periods of 10 years or more, long-term investors should seriously consider passive investing.