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Ask a Fool: Should I Invest in Index Funds or Actively Managed Mutual Funds?

By Matthew Frankel, CFP® - Feb 23, 2018 at 12:00PM

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Fund managers should be able to beat the market, right?

Q: Are index funds or actively managed mutual funds the smarter choice?

There isn't an easy answer, but here are the key differences and some facts that could help you make your decision. In general, however, I think index funds are the best investment for most people who don't have the time or desire to research individual stocks.

The key advantages of index fund investing are cost and the guarantee of matching the market's performance.

Because the fund's managers don't actually need to do any stock picking, index funds tend to have significantly lower fees. For example, the average actively managed large-cap stock fund has an expense ratio of 1.25% while the average S&P 500 index fund charges a minuscule 0.15%. Over time, this difference can really add up.

And while they'll never beat the market's performance, by definition index funds guarantee that you'll do as well as the market over time. The S&P 500 has historically generated annual returns of nearly 10%, so this can effectively build wealth over time, especially with the low fees.

On the other hand, actively managed mutual funds have the chance of beating the market, but their fees put them at an inherent disadvantage. As legendary investor Warren Buffett has explained it, if half of fund managers beat the market and half don't, when you account for the fees, the average fund will underperform.

The statistics confirm this. Just 1 in 3 active managers of large-cap funds were able to beat the S&P 500 in a recent year, and the figures were even worse for mid-cap and small-cap fund managers. And over the last 15-year period, a staggering 92% of large-cap managers underperformed the market.

That said, if a fund has a particularly strong and sustained record of performance, it could be worth the additional fee. For the most part, however, index funds are the better bet.

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