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Ask a Fool: Which Are Better -- Index Funds or Actively-Managed Mutual Funds?

By Matthew Frankel, CFP® - Sep 8, 2017 at 12:05PM

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With an index fund, you're never going to get better than average returns. But active managers don't usually beat the market either.

Q: Are actively managed mutual funds better investments than index funds?

Not necessarily. In fact, there’s a better case to be made in favor of index funds.

Perhaps the biggest difference between the two types of funds is their cost. Actively managed mutual funds employ highly-compensated professional investment managers to choose their holdings, and therefore tend to charge higher fees. Index funds, on the other hand, simply buy the stocks or bonds in a certain index, which allows them to operate with less overhead -- savings they generally pass on to customers. You can find index funds with expense ratios as low as 0.03%, while even a "cheap" actively managed mutual fund might have a 0.50% ratio.

Another difference between them lies in their objectives. Actively managed funds are looking to beat the market, which means making strategic bets. In any given year, some funds' bets will win, while others will lose. Index funds are, by definition, guaranteed to match the performance of the underlying index, minus your (hopefully) low fees.

But despite their goal of outperforming the market, actively-managed funds as a whole have had a poor track record. In fact, the large majority missed their benchmarks over 1-,3-,5-,10-, and 15-year time periods, according to S&P Dow Jones Indices -- and over the 15-year time frame, more than 90% of active fund managers underperformed. This could explain why passive funds saw more than half a trillion dollars in inflows in 2016, while active funds had more than $340 billion in net outflows.

Because of their low cost and virtual guarantee not to underperform the market (or their underlying index), many experts say that low-cost index funds are the smartest way for the majority of Americans to invest. Even billionaire investing genius Warren Buffett has said that a simple S&P 500 index fund is the best way to bet on the future of America, and has actually directed that his wife's inheritance be invested in such a fund after he's gone.

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