Index Funds vs Actively-Managed Funds

With such a wide variety of investment products available, it can be confusing to know what exactly to invest in — even with easy-to-manage investments like mutual funds.  Investors have a huge range of styles — from conservative to aggressive, and everything in between.  Of course when trying to pick mutual funds, an investor wants a line up of top-notch performers, and not underperforming money hogs.  So it’s important to know your risk tolerance, and to do your due diligence before selecting a mutual fund or group of funds.

This article aims to help you with the investing portion of your financial plan by comparing two categories of funds:  index mutual funds and actively-managed mutual funds.

Index Mutual Funds

Simply put, an index mutual fund is an investment product designed to replicate the movements of an index of a specific financial market. For example, an S&P 500 index fund is designed to replicate the movements of the S&P 500 index. The fund manager simply tries to make the returns of the benchmark and not to outperform the market.

Index funds are perfect if you don’t want to spend the time researching and following the performance of various funds. This conservative investing approach will work if you are not trying to beat the market and simply want a slight to moderate capital growth. These funds also have a low expense ratio, and that means more money for you to keep.  Lastly, they work very well in taxable accounts, because they are more tax efficient due to infrequent buying and selling of securities (low turnover ratio).

Actively-Managed Mutual Funds

If you have time to do research and monitor fund performance, actively managed funds may be for you.

Managers of these funds stay on top of the market, buying and selling as market and economic conditions change. For example, if a downturn occurs, they often liquidate some of the fund investments to cash. This also means that they will invest more aggressively in a bull market, because their long-term goal is to beat benchmark indexes. They also tend to be more widely diversified and invest a larger variety of securities.

In term of tax efficiency, actively managed mutual funds, tend to be better suited for tax-advantaged accounts — such as an IRA or a 401(k) — because their higher turnover ratio could translate into more costs to you in a taxable account.

Editor’s Note: It should be noted that the majority of actively-managed mutual funds do not outperform index mutual funds in the long-term due to two inherent disadvantages: (1) higher expense ratio, and (2) lower tax efficiency.

What to Look For In Actively Managed Funds

In order to ensure the best performance possible with an actively managed fund, there are a few simple criteria you should consider.

The first thing to analyze is long-term fund performance.  If the fund hasn’t done well up to this point, move on.  If the history looks solid, the first step of analysis is complete.  Of course the past performance won’t necessarily dictate future results, but having a history of outperforming the market is a definite plus.

Next, you should take the time to understand what the basic investment process is for a particular fund.  Read the manager’s investment process in fund prospectus — it should be well-defined and easy to understand.

Finally, who is the management team for the fund?  Again, read the prospectus carefully and find out who the fund managers are, and how long they have been involved with the fund.  It’s recommended that they be actively involved with the fund for three years or more.

Which way to go?

If you have the time to monitor your actively managed funds, this might be the right investments for you.  Otherwise you may want to stick with the index funds.  Keep in mind that investing for the long-term, whether buying stocks or mutual funds, is the best approach for making your retirement wishes come true. In the short-term actively managed funds often will underperform index mutual funds.  Of course having a mix of index and actively managed funds in your portfolio can be great for balancing your strategy.

About the Author

By , on May 12, 2010
David Hamilton (aka FPT Guy) is owner and author of Financial Planning Tips - where you can find information on a wide variety of topics around personal finance. Besides being passionate about his finance blog and helping others keep their finances in check, David also enjoys playing music, staying healthy, spending time with family and friends, and traveling the world.

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Leave Your Comment (4 Comments)

  1. ctreit says:

    It is probably as difficult to pick a good mutual fund as it is to pick a good stock. Even a long-term track record cannot predict future performance, which is why every mutual fund tells you in the prospectus, “past performance is no guarantee….” One of the most famous fund managers to have fallen from grace recently is Bill Miller of T. Rowe Price whose 20+ years of an excellent track record got squashed very quickly.

  2. William says:

    Nice post.

    Whether you are for or against the Efficient Market Hypothesis, It takes a very rare investor to be able to beat the market consistently. The higher fees and transaction costs do eat up many gains one might perceive. Fidelity, Vanguard and T. Rowe Price offer extremely low cost index funds that will provide an excellent return over the long haul as all of the ‘costs not incurred’ are shovelled back into the investment.

    I tend to like the ‘whole market’ indices as touted in Burton Malkiel and Charles D, Ellis’ recent little book “The Elements of Investing”. I wrote a review of it recently. Let me know what you think:

    A bulk of my investments are in Extended Equity Index funds and Bond Funds but I have to admit that I have a few Actively Managed sector funds (I bought shares of Real Estate and Financial Services funds when the crisis was full bore). But I realize that these were not investments but rather speculations. Investments are a purchase of value, speculation has no interest in the value of the underlying security, only the potential for it’s share price to rise.

    Anyway. I like the article. It’s A topic I am very interested in learning more about.


  3. kt says:

    i am for the index mutual fund because the actively managed mutual funds will definitely have more fees than the index mutual fund. I mean lets be real, you invest in any security because you want the best of returns so it makes no sense to reduce those returns because with unnecessary (hidden) fees. I also see the point of the balancing between the two because there is really no way of knowing what will happen in future

  4. Doctor S says:

    Index funds are perfect for the normal investor of today that does not want to worry about their funds. With actively managed funds, you deal with the day to day stress/joy of monitoring whats going on in your fund. Many people do not have time for that. Index funds really do offer a great engine to set up your choice and let them sit there. Especially over the last few weeks, people can make themselves go crazy by trying to beat the market during extreme times.

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