Index funds are often passively managed funds following a benchmark index like NASDAQ 100. They aim to generate similar returns to their benchmarks.
An actively managed fund incurs higher costs and is a riskier option. However, it offers an incentive for higher returns.
What is an Index Fund?
An index fund is a fund that tracks or follows a benchmark financial index. It is a portfolio of financial assets that contain the same assets as its benchmark index.
Index fund managers often passively manage the fund by following the investing style of its benchmark index. Commonly followed index funds include S&P500, NASDAQ 100, and Dow Jones Industrial Average (DJIA).
The portfolio of financial assets of an index fund will remain the same as that of the index it is following. For instance, if an index fund follows the S&P500, it will invest in the top 500 companies in the US as the S&P500 does.
How an Index Fund is Managed?
Index funds do not look to beat the market usually. An index fund aims to match the return of the benchmark index.
Index tracking is automatic. Hence, the index fund will automatically track and adjust when the index changes its portfolio.
Therefore, an index fund will mirror the performance of its benchmark index in the long run. This investing style is less costly as it involves fewer transactions.
The portfolio of an index fund will depend on the index’s portfolio it follows. It can follow an all-stock, all-bonds, or a mix of financial assets by choosing one of the several available indices.
Index funds can be actively managed too. Index fund managers can rebalance the portfolio by removing the underperforming assets.
Active index fund managers regularly add or remove financial assets from the bucket. Unlike passive funds, these funds look to better the benchmark return by constantly adjusting the portfolio mix.
There are hundreds of index funds and each financial market has a different range of indices as well. So, you can pick from an all-stock index fund to actively managed index funds.
Here are a few popular index funds in the US:
- Schwab S&P 500 index fund
- Fidelity ZERO large-cap index fund
- Vanguard Growth ETF
- SPDR S&P Dividend ETF
- Shelton NASDAQ 100 Index Direct
- iShares Core S&P500 Direct
Index funds follow many benchmark indices. The most widely followed indices are:
- Standard and Poor’s 500
- Dow Jones Industrial Average
- NASDAQ Composite
- Russel 2000
Pros and Cons of Index Funds
Index Funds come with several advantages:
- Investing in an index fund is cheaper as compared to any actively managed investment. There are fewer transaction costs as well as research costs.
- Tax rates on long-term capital gains are also lower as compared to active trading gains. Therefore, these funds also provide tax incentives to investors in the long run.
- Index funds come with a naturally diversified portfolio. It means investors do not need to rebalance the investment bucket actively.
- As the historic results have shown, index funds can outperform active investments in the long run as the market tends to rise eventually.
- Index funds can be managed actively and generate higher returns than their benchmark with careful planning.
Some disadvantages of Index Funds include:
- Index funds provide an average return on investment when their benchmark funds perform well. If the index they track does not perform well, their return will also suffer.
- Index funds may follow a poor index and can result in losing value over the long run.
- Index funds generate sufficient returns in the long term only.
What is an Actively Managed Fund?
Active funds are funds where the investment portfolio is hand-picked instead of following an index.
Active management involves constantly buying and selling financial assets in a portfolio. The aim is to generate maximum profits and not hold back to match the returns of an index.
In other words, actively managed funds look to beat the market with careful planning and execution. This approach requires taking more risks than managing an index fund.
Active fund managers prefer volatile markets and assets to generate more profits. Also, they look to maximize short-term gains over the long-term game of index funds.
How Does an Actively Managed Fund Work?
An actively managed fund also tracks an index. However, the key difference from an index fund is the approach it takes.
The main investment objective of an actively managed fund is to produce a better return on investment than the benchmark it follows. It then includes generating a higher ROI, reducing costs, and lowering tax burden among other objectives.
An actively managed fund can comprise stocks, bonds, and other financial securities individually or in a combination of these assets.
Active fund managers will consistently remove underperforming financial assets and replace them with other assets. So, it gives fund managers more freedom to choose financial assets to invest in.
At the same time, active fund managers must conduct extensive market research. It increases fund management costs significantly.
Similarly, constantly changing the investment portfolio means taking more risks than a passively managed fund.
Actively managed funds can comprise different types of financial assets and follow different indices worldwide. Most actively managed funds are either mutual funds or exchange-traded funds (ETFs).
Some of the well-known and successful actively managed funds over the years are given below:
- Vanguard Total Stock Market Index Fund Admiral Shares (VTSAX)
- Vanguard Total International Stock Index Fund Admiral Shares
- The Schwab Total Stock Market Index Fund (SWTSX)
- ARK Innovation ETF
- First Trust Long/Short ETF
- T. Rowe Price Dividend Growth
- Fidelity Large Cap Core Enhanced Index
- BlackRock Exchange BlackRock
- Fidelity Flex 500 Index
Pros and Cons of Actively Managed Funds
Actively managed funds come with some discrete advantages and risks.
Pros of actively managed funds include:
- Well-managed active funds can outperform their benchmark indices in the long run. However, it takes considerable time and risks.
- Fund managers can follow a benchmark index first and then adjust the portfolio by removing the underperforming assets.
- It’s easier to measure the performance of an actively managed fund as it’s not restricted only to following the index benchmark.
- Investors can protect their investment goals during market downturns with active management.
Some disadvantages of actively managed funds include:
- Active funds are riskier than passively managed funds, both in the short and long term.
- Transaction costs, taxes, conversion costs, and the overall expense ratio of active funds are significantly higher than passive funds.
- There is no guarantee that active funds will generate higher returns than benchmark indices.
- Active management requires substantial research, extensive knowledge, special skills, and constant investment portfolio monitoring.
Index Fund Vs Actively Managed Fund – Which One is a Better Investment?
Actively managed funds like Fidelity Blue Chip Growth Fund can beat their benchmark indices in the short term. However, there is no consensus that it will happen to all active funds.
Generally, most active funds fail to generate higher or equally good returns to their benchmark indices. In other words, it’s difficult to beat the market in the long run.
Index funds are passively managed and generate similar returns to their benchmarks. They’re also more efficient than active funds in the long run.
Index funds come with lower expense ratios as compared to active funds. They incur lower capital gains taxes as well.
Overall, index funds are better investment wheels than actively managed funds if you’re looking for long-term investment goals.