Actively managed funds and index funds are similar in that they’re both a type of pooled investment fund, and they both come in a variety of styles (e.g. large cap, small cap, green bonds, and so on). The main difference between them is that actively managed funds rely on a team of live portfolio managers vs. index funds, which simply track or mirror a relevant index using an algorithm.
The difference in management style between active and so-called “passive” index funds leads to a series of other differences, including cost and transparency around securities in the fund.
The debate concerning the merits of actively managed funds vs. index funds is a longstanding one. Both types of funds have the potential to yield advantages to investors. But they each have drawbacks that should be weighed in the balance.
What Are Index Funds?
Index funds are a type of mutual fund or exchange-traded fund (ETF) that mirror the performance of a specific stock market index.
A stock market index measures a particular sector of the market. In the case of the S&P 500 Index, for example, what’s being measured is the performance of the 500 largest U.S. companies.
While it’s not possible to invest in an index directly, index funds and ETFs offer a work-around because when you invest in an index fund, you’re purchasing a fund that holds securities which are representative of its representative index.
If you’re buying a fund that tracks the Nasdaq-100 Composite Index, for example, the fund would include stocks from the 100 largest and most actively-traded non-financial domestic and international securities listed on the Nasdaq. The securities are not hand-picked by a portfolio manager, and an index fund doesn’t seek to outperform the benchmark — but rather to match it.
Index funds can be cap-weighted, meaning they track an index that relies on market capitalization to decide which securities to include. Market capitalization is a company’s value as determined by its share price multiplied by the number of shares outstanding.
For example, some index funds only track large-cap companies that have a market capitalization of more than $10 billion. Others focus on small-cap companies that have a market capitalization of $250 million to $2 billion.
Index funds and index investing follow a passive investment strategy. That means that the fund tracks the performance of a particular benchmark, rather than trying to beat the market by using the skills of a live portfolio manager.
💡 Quick Tip: Before opening an investment account, know your investment objectives, time horizon, and risk tolerance. These fundamentals will help keep your strategy on track and with the aim of meeting your goals.
What Are Actively Managed Funds?
Actively managed ETFs and mutual funds also represent a collection or basket of securities. The difference between these types of funds and index funds is that instead of being passively managed and tracking a specific index, a fund manager plays a hands-on role in determining which securities to include, in an attempt to beat the market.
Because of that, fund turnover — the movement of assets in and out of the fund — may be more frequent compared to an index fund. This has certain tax and cost implications for investors.
Index Funds vs Actively Managed Funds
Index funds do have some similarities to actively managed funds, but the chief difference between them — i.e. the use of passive management vs. active management — yields some important other differences.
| Index Funds | Active Funds | |
|---|---|---|
| Types of securities | All securities (stocks, bonds, etc.) | All securities (stocks, bonds, etc.) |
| Investment objective | To mirror its benchmark | To outperform its benchmark |
| Management style | Passive (securities in the fund match the index) | Active (fund managers select securities in the fund on the basis of performance) |
| Cost | Average expense ratio is about 0.03 to 0.05% | Average expense ratio is about 0.50% to 0.75% |
| Tax efficiency | Less turnover, more tax efficient | Higher turnover, less tax efficient |
Similarities
As noted above, both types of funds are pooled investment funds. You might have passively or actively managed mutual funds as well as exchange-traded funds.
Both types of funds can be invested in a wide range of different equities, bonds, and other securities. For example, you might have a small-cap ETF that’s passively managed (perhaps it tracks the Russell 2000 small-cap index) or an ETF that’s actively managed and also invested in small-cap companies.
Differences
The chief differences between actively managed funds show up in terms of cost and tax implications, and performance.
Actively managed funds are generally more expensive than index funds, because the fund employs a team of active managers who hand-pick securities and trade them.
Active funds also have a different investment objective: to beat the market. Index funds merely seek to mirror the performance of its benchmark index.
So a large-cap actively managed fund might seek to outperform the S&P 500, whereas a large-cap index fund that tracks the S&P 500 would aim to deliver the same results as the index itself.
💡 Quick Tip: When you’re actively investing in stocks, it’s important to ask what types of fees you might have to pay. For example, brokers may charge a flat fee for trading stocks, or require some commission for every trade. Taking the time to manage investment costs can be beneficial over the long term.
Pros and Cons of Index Funds
There’s a lot to like about index funds but with any investment, it’s important to consider the potential downsides. Reading through an index fund’s prospectus can offer more insight into how the particular fund works, in terms of what it invests in, its risk profile, and the costs you’ll pay to own it. This can help you better gauge whether a particular index fund aligns with your investment strategy.
When weighing index funds as a whole, here are some important points to keep in mind.
Index Fund Pros
• Simplified diversification. Diversification may help manage risk inside a portfolio. Index funds can make diversifying easier through exposure to multiple securities that represent a specific index.
• Cost. Because they are passively managed, index funds typically charge fewer fees and carry expense ratios that are well below the industry average of 0.57%. Fewer fees allow you to keep more of your investment returns.
• Tax efficient. Index funds tend to turn over assets less frequently than actively managed funds, which means fewer capital gains tax events — another way index funds can save investors money.
• Consistent returns. The idea behind an index fund is that it will closely track its benchmark to mirror performance. Index funds can offer stable returns over time when they perform in tandem with their respective indices.
Index Fund Cons
• Underperformance. Index fund returns can differ from one fund to the next and factors such as fees, expense ratios, and market conditions can affect how well a fund performs. It’s possible that rather than matching its benchmark, an index fund may deliver returns below expectations.
• Cost. Between index funds vs. managed funds, index funds tend to have lower costs — but that’s not always the case. It’s possible to invest in index funds that prove more expensive than actively managed funds.
• Tracking error. Tracking error occurs when an index fund’s performance doesn’t match the performance of its benchmark. This can happen if the fund’s makeup doesn’t accurately reflect the makeup of securities tracked by the index.
• Limit on returns. Index funds aren’t designed to beat the market. Investing in these funds, without considering active investing strategies, could limit your return potential over time and cause you to miss out on bigger investment gains.
Why Invest in Index Funds?
Index funds and index investing may work better for a buy-and-hold investor who’s focused on investing for the long-term. Buy-and hold-strategies often go hand in hand with value investing strategies, in which the emphasis lies on finding companies that are undervalued by the market.
Utilizing index funds could simplify investing over the long term, and it may suit people who want to minimize risk-taking in their portfolios. But it’s important to consider the trade-offs involved with choosing index funds vs. actively managed funds.
Pros and Cons of Actively Managed Funds
With active funds, fund managers use their knowledge and expertise to determine which securities to buy or sell inside the fund in order to reach the fund’s investment goals.
As with index investing, using actively managed funds to invest can have its high and low points. Here are some key things to know about investing with actively managed funds.
Actively Managed Funds Pros
• Professional expertise. Actively managed funds allow investors to benefit from a fund manager’s know-how and experience in the market. This may be reassuring to an investor who’s still learning the ropes of how trading works, or who has faith in a particular fund manager.
• Higher returns. Actively managed funds seek to outperform the market. If the fund realizes its objectives, returns could possibly exceed those offered by index funds. Historically, though, the majority of active funds don’t outperform the market.
Actively Managed Funds Cons
• Underperformance. As with index funds, it’s possible that an actively managed fund’s returns won’t meet investor expectations. This can happen if the fund manager makes a miscalculation when choosing securities or unforeseen events, such as a major economic downturn, deliver a blow to the market.
• High management fees. The costs associated with having a fund manager make decisions are typically higher than with passively managed index funds.
• Risk. Active trading can be riskier than index investing, since performance relies on the fund manager to make buying and sellings decisions.
• Taxes. Since asset turnover is higher for actively managed funds, more capital gains tax events are likely. Even though an actively managed fund may generate higher returns, those have to be weighed against the possibility of increased tax liability.
Why Invest in Actively Managed Funds
Actively managed funds may offer more downside than upside to investors. Unlike index funds, actively managed funds may not be suited for a long-term, buy-and-hold strategy. But for investors who have the time or inclination to take their chances for a greater potential yield, they might be an attractive part of a portfolio.
Are Index Funds Better than Managed Funds?
Both actively managed funds and index funds aim to help investors achieve their goals, but in different ways and with potentially different results. Whether index funds or managed funds are better hinges largely on the individual investor and what they need or expect their investments to do for them.
When considering index funds and actively managed funds, ask yourself what’s more important: Steady returns or a chance to beat the market? While actively managed funds can outperform market indices, results aren’t guaranteed and in some cases, active funds can lag behind their benchmarks.
Index funds, on the other hand, may offer a greater sense of stability over time and potentially more insulation against market volatility. While all investments carry the risk of loss, over time there may be a smaller chance of losing money in an index fund. But there are no guarantees.
Lower investment costs can also be attractive when estimating net returns, but again it’s important to compare fund costs against fund performance individually, to ensure that you’re comfortable with the number.
The Takeaway
Whether you prefer index funds vs. managed funds might depend on your age, time horizon for investing, risk tolerance, and goals. If you lean toward a hands-off, goals-based investing approach that carries lower costs, index investing could suit you well.
On the other hand, if you’re more interested in beating the market, and if you believe active management is more likely to deliver outperformance, then you may consider the benefits of active investing.
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