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 for growing a portfolio. But they each have drawbacks that should be weighed in the balance.
What works well for one investor may not be suitable for another and it’s important that your choice of funds reflects your needs and objectives. Understanding the differences between index funds vs. actively-managed funds can help with investment decision-making.
Index Funds Explained
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 500 largest U.S. companies. While it’s not possible to invest in an index directly, index funds and ETFs offer a work-around.
When you invest in an index fund, you’re purchasing a fund or ETF that holds securities which are representative of its underlying 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.
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 manager doesn’t buy and sell assets within the fund as often. Instead, the fund maintains more or less the same mix of securities over time. In terms of performance, index investing is more about matching the returns of a particular benchmark rather than trying to beat the market.
Actively-Managed Funds Explained
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, in these cases 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.
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 is important for managing 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—for example, if an investor is older, or the investments are earmarked for retirement. 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 actively-managed 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.
• 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.
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 vs. 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 it’s possible, there is less of a change of losing money in an index fund. 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.
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 then you may consider the benefits of active investing.
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