6 min. read

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.

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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 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 page in our FIRE Guide.

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.

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?

Stock market graph

How Are the Holdings of Index Funds Vs. Active Funds Chosen?

As we’ve stated, active funds are, well, actively managed. 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!
No Monkey Business in Investing in Index Funds

Index Funds Vs. Active 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.

Personal Capital's Fee Analyzer

Personal Capital has a free valuable financial tool that compares the fees you are being charged for index funds vs. active funds. You can use this analysis to see how the fees are affecting your overall portfolio growth, and how it will affect it long-term.

FIRE and Index Funds

The FIRE movement loves index funds. We are specifically fans of the Vanguard Total
Stock Market Index Fund
.

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 3,637
stocks for total net assets in the vicinity of $814 billion. 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 index mutual fund 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 a 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 judgement 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 is your own
choice. 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!