Are you putting your money at risk by investing in the wrong type of funds? Deciding between index funds vs active funds can affect your overall portfolio growth over time.
The goal of every investment strategy is to make money. Not just a bit of money. But enough money to lend to early retirement and a cozy lifestyle in our post-work years. Both index funds and active funds make a great addition to any investment strategy, in large part because of their flexibility.
Because the risk level of any fund depends on what it invests in, you can build a pretty solid portfolio by padding it with investments that align with your risk tolerance. That being said, even an experienced investor needs to weigh the pros and cons before deciding to include either type of mutual funds or exchange traded funds (ETFs) in their portfolio.
Three main characteristics differentiate the two – the funds’ unique objectives, how the holdings of each fund are decided, and their cost of management. Let’s dig into that a little deeper!
Want to learn more about investing? Visit the Investing chapter of our FIRE Guide!
Table of Contents
What Are the Different Objectives Between Index Funds Vs Active Funds?
The investment goal of an index fund is to match the performance of its underlying benchmark. In this case, anything that is bought or sold in the benchmark is also acquired or released by the index fund. Generally speaking, index funds are a stable investment option, since their respective underlying benchmarks have been market or lab tested for optimal returns.
Contrary to index funds, actively managed funds seek to outperform their benchmark. Theoretically, an active fund would see greater returns than an index fund because its manager is keeping a hawk’s eye on the market and adjusting the fund accordingly.
However for the past ten+ years, active fund managers have trailed the returns of benchmarks like the S&P 500.
Is this strategy really the way to go in order to capitalize on maximum returns? Or is the index fund’s “set it and forget it” approach a better way to make money in the stock market?
How Are the Holdings of Index Funds Vs Active Funds Chosen?
As we’ve stated, active funds are, well, actively managed mutual funds. This means that a fund manager watches and researches the market in order to make decisions regarding the fund’s holdings. This sometimes means making hourly choices on the investor’s behalf, purchasing or punting stocks and bonds that align with the portfolio’s investment strategy.
Index funds are considered a passive investing strategy. Countering the illusion given by actively managed funds – one of a manager sitting red-eyed at his or her desk, obsessively watching for shifts in the market – index funds feel like a white sand beach with a cold mojito in hand while your investments do the
work for you.
While the general theory driving active funds is well-intended, Vanguard has proven that actively-managed funds outperforming their indexes are very hard to find. A contributing factor to this is the costs associated with the management of the fund itself.
There has actually been research done showing that monkeys choose stocks better than active fund managers by throwing darts at potential portfolios. No, we’re not monkeying around!
Active Funds Vs Index Funds: Cost of Management
With more active involvement in the management of your funds, comes higher management fees.
Nobody works for free, and that includes the person managing your investments. All of the costs related to managing your portfolio – from salaries to staplers – are bundled into the expense ratio that you pay.
Since active funds require constant interference, they cost more to manage than index funds. On average, you are looking at an expense ratio of 0.82% for an actively managed fund, versus 0.09% for an index fund.
Getting down to brass tacks, that means that on a $1,000 annual investment earning 7%, you would pay $13,200 more in fees alone over a 30-year period by investing in an active fund instead of an index fund.
But wait – isn’t the goal here to earn money, not lose it? Vanguard again chips in by stating that while the idea is nice, “over longer time frames the added expense of active management often proves too much to overcome” for most actively managed funds.
They also shine a light on the pervasive trend of actively managed funds to be more volatile than their index fund counterparts. Higher volatility and higher management expenses mean that actively managed funds have the tendency to defeat their own purpose, by losing their gains through their cost of management.
Not to mention, the high turnover of stocks within actively managed funds causes an increase in the amount of taxes you pay in taxable nonretirement accounts.
FIRE and Index Funds
As a diversified fund, it offers an unbeatable investment for those seeking lower volatility and cost. The expense ratio sits at a low 0.04%, and it combines over 4,000 stocks for total net assets over one trillion dollars. It is easy to see why this is an attractive addition to any FI-ers portfolio.
In terms of wealth-building strategies, why do we believe that index funds make up the most effective investment?
It’s easy. We believe that simple is best. And you can’t argue with the simple low-cost diversity of a good index fund. And this was the entire philosophy behind John C. Bogle’s decision to create the world’s first mutual funds in 1975.
Having spent a better part of his life submerged in the world of banking and investments, he easily recognized the systemic issues with actively managed investments. Attempting to beat an index, and paying extravagantly in order to do so, simply didn’t make sense to him.
During his career with Vanguard, and even thereafter, he advocated adamantly for the superiority of index funds over actively managed funds, claiming it a folly to expect to beat a low-cost index fund after accounting for the fees that active funds incur.
Index funds clearly just make sense for any long-term investor.
The Final Verdict
By digging through all of the data, it becomes pretty evident that there is no competition between index funds vs active funds. Index funds are better than active funds in terms of building a lucrative investment portfolio. The cost of managing an active fund is a major deterrent for most people. You also have to factor human error into the mix.
An actively managed fund opens itself to losses that can be incurred by a simple error in judgment made by even the most experienced portfolio manager. This margin of error is eliminated by investing in an index fund that mirrors a tested benchmark. Ultimately, where you invest your earnings will depend on your circumstances and investment objectives.
You can also seek investment advice from financial advisors and experts who can also advise you on how investment performance is measured. But historically speaking, actively managed funds have dropped the ball on their promise to outperform their benchmarks over long-term investment horizons.
Do you have index funds, actively managed funds or a combination in your portfolio? Let us know in the comments!
Samantha Hawrylack is a personal finance expert and full-time entrepreneur with a passion for writing and SEO. She holds a Bachelor’s in Finance and Master’s in Business Administration and previously worked for Vanguard, where she held Series 7 and 63 licenses. Her work has been featured in publications like Grow, MSN, CNBC, Ladders, Rocket Mortgage, Quicken Loans, Clever Girl Finance, Credit Donkey, Crediful, Investing Answers, Well Kept Wallet, AllCards, Mama and Money, and Concreit, among others. She writes in personal finance, real estate, credit, entrepreneurship, credit card, student loan, mortgage, personal loan, insurance, debt management, business, productivity, and career niches.