Mutual Fund Basics: Index Funds vs. Actively Managed Funds

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John Bogle knew from the beginning that index funds were cheap to run. Linking investments to an index takes a lot less time and effort than actively scouring the market for promising stocks. And because they're so cheap, index funds stand an excellent chance of beating the average managed fund's performance -- by as much as 1.5% a year, according to Bogle's estimates in his initial presentation to the Vanguard board.

The intervening years have proved Bogle even more correct than he knew. Index funds' inexpensive nature provides one of their greatest advantages over most actively managed funds.

Are all managed funds run by morons?
Not at all! On average, most fund managers pick stocks that more or less equal the overall performance of the market. Instead, Bogle cites four factors that give index funds the edge:

• Costs: As mentioned above, index funds carry much lower expense ratios than their actively managed brethren.
• Turnover: Index funds trade in and out of stocks less often than active funds do, saving on commissions, taxes, and other trading costs.
• Sector: By choosing to favor certain sectors, active funds' returns tend to differ from those of indexes.
• Cash reserves: Because active funds typically keep a significant amount of cash reserves, active fund managers are never fully invested, which means they'll lose out on the steady growth accrued by index investments.

So I should never buy actively managed funds?
In most cases, index funds will be your best bet for solid investing performance. But the downside of index funds is the same as their upside: You'll only do as well as the rest of the market. If you have confidence that individual managers are smart and disciplined enough to pick investments that will beat the market -- and beat it by a wide enough margin to recoup the additional expenses they charge -- then an actively managed fund may be a better option for you.

There are some funds -- or more precisely, some fund managers -- who truly earn their keep. They're not only superior investors, but also determined to keep their fees reasonably low. To find them, see our section on picking the perfect fund. Otherwise, continue to our next segment, where we'll discuss other types of fund investments.