Mutual fund investors have an important choice to make when they pick funds: whether to choose funds that are actively managed or funds that track benchmark indexes passively. There are pros and cons to each method, and there's heated debate over which strategy is best. Numerous studies have shown that the average actively managed fund tends to underperform index funds with similar investment objectives, but a few standout active funds have crushed indexes over the long haul.
Your investing temperament might be the most important factor when you're deciding whether passive index funds or actively managed mutual funds are right for you.
The main difference between index funds and mutual funds
What really sets index funds apart from actively managed mutual funds is that with index funds, you always know what you're getting. An index fund that tracks the S&P 500 will provide a return equal to that of the S&P 500, less any expenses that the fund incurs. Index funds typically have low costs, with the cheapest choices charging less than 0.1% per year in expenses.
By contrast, actively managed mutual funds have a broad mandate to invest in stocks that meet certain criteria. You can find out what a fund holds when it releases its portfolio holdings in its SEC-required reports, but those holdings are out of date by the time they're printed, and funds are not required to update investors on their latest holdings. Indeed, the semi-secret nature of an actively managed fund's proprietary picks is what gives it a chance to outperform its index-tracking counterparts. However, actively managed funds are almost always more costly, and annual fees of 1% or more are fairly common.
What the statistics show
When you look at recent history, actively managed funds have performed poorly compared to index funds. According to Morningstar, two-thirds of large-cap growth stock mutual funds underperformed the index, and nearly three-quarters of large-cap blended funds failed to match their benchmark. The same was true in 2014, when 86% of active large-cap fund managers fell short of their benchmarks.
The trend is the same over the long term. One study found that more than four-fifths of active fund managers could not keep up with their benchmarks.
The result has been a major shift in the flow of investing money, with more money going into index funds and less going in actively managed funds. In fact, the rise of exchange-traded funds -- nearly all of which are index-tracking investments -- has led to outflows from actively managed mutual funds as investors seek better returns. Similar trends have occurred in bond market investing, even though the advantage of passive bond index funds over actively managed bond funds is less clear-cut.
Overall, index funds that let you invest cheaply in a representative sample of stocks can be a very efficient way to invest. However, if you can stomach risk and feel confident that you can find the rare actively managed fund that will outperform the benchmarks, then you're free to try to beat the odds and go the active route.
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