What are index funds?
Index funds are considered passively managed. An index fund manager attempts to replicate the returns of the index it tracks by buying all (or most) of the assets contained in the index. Hundreds of markets can be accessed through mutual funds and exchange-traded funds.
What are actively managed funds?
An active management fund portfolio manager seeks to outperform the market by selecting investments. The manager performs in-depth analysis of various investments to exceed the market benchmark, such as the S&P 500.
Should you own index funds or actively managed funds?
One advantage that actively managed funds have over index funds is the ability to outperform the market, and this concept of outperformance attracts investors. After all, why settle for an index fund when you know you will only get market returns, minus a nominal fee for the fund manager?
Unfortunately, it is difficult to find evidence that actively managed funds can consistently outperform their relevant index. It is even harder for the individual investor to identify the active fund that will outperform the index in a given year.
According to Vanguard, in a study comparing index funds versus active funds, for the ten-year period ending June 30, 2020, 180 out of 205 Vanguard funds outperformed the averages of their peer group. 9 out of 9 Vanguard money market funds, 57 out of 66 Vanguard bond funds, 22 out of 23 Vanguard balanced funds, 92 out of 107 Vanguard stock funds.
However, it should be noted that most Vanguard funds are index funds. Nonetheless, these results show the advantage of passive investing over active investing in the long term.
Active Management: Luck or Skill?
You may point out that some funds have indeed outperformed their benchmarks, so why not invest in those funds? How do we know if the active manager is skilled at selecting investments or just lucky? Evidence from a study by Barclays suggests that the chance of sustained outperformance is slim for an active manager to continue outperforming the index.
Index Funds vs. Active Funds: Cost
Actively managed funds start out lagging behind index funds. The average ongoing management cost of an active management fund is 1% more than a passively managed index fund. Cost is another issue that contributes to the underperformance of active management funds relative to their benchmarks.
Index Funds vs. Active Funds: Tax Efficiency
Another problem, which does not show up in the fund’s return numbers, is that the active management fund manager – in search of higher returns – buys and sells investments more frequently than an index fund. This buying and selling of stocks by the active manager – known as “turnover” – leads to capital gains that are taxable for the fund shareholders if the fund is held in a non-retirement account.
Conclusion
As with any investment decision, the best type of fund to buy depends on the individual investor’s circumstances and goals. While history shows that there are good active managers, finding such managers before they outperform is difficult. Given that index funds have historically outperformed most actively managed funds over periods of more than 10 years, long-term investors should seriously consider passive investing.
Frequently Asked Questions (FAQs)
What are mutual funds?
A mutual fund is an investment vehicle that pools investor money and purchases a diverse array of securities. Mutual funds can buy stocks, bonds, and other assets. They can help diversify investors’ portfolios and simplify their investment decisions.
How
Are you investing in mutual funds?
First, decide which mutual funds you want to invest in. Look at the minimum investment required, whether the fund is actively managed or passively managed, the expense ratio, and what the fund invests in. Once you’ve decided which mutual funds appeal to you, open a brokerage account to invest in those funds.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts in our articles. Read our editorial process to learn more about how we fact-check and maintain the accuracy, reliability, and quality of our content.
Vanguard. “Index Funds vs. Actively Managed Funds.”
Barclays. “The Science and Art of Manager Selection: Barclays Research on the Manager, Page 6.”
Source: https://www.thebalancemoney.com/index-funds-vs-actively-managed-funds-2466445
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