Index vs Managed Funds
The portfolio manager of an actively-managed fund tries to beat the market by picking and choosing investments. The manager performs an in-depth analysis of many investments in an attempt to outperform the market index such as the S&P 500. Conversely, on the other end is the Index fund.
Index funds are considered to be passively managed. The manager of an index fund tries to mimic the returns of the index it follows by purchasing all, or almost all of the holdings in the index. They tend to have lower fees than actively managed funds.
The potential to outperform the market is one advantage that actively-managed funds have over index funds, and this notion of outperformance is attractive to investors. However, evidence that actively-managed funds can consistently outperform their relevant index is difficult to find. It’s even more difficult for an individual investor to pick the actively-managed fund that will outperform the index in a given year and most of the time actively managed funds underperform index funds. Many years as much as 85% of active fund managers underperform the S&P 500 index, making index funds more attractive option.
Which one performs better?
According to Vanguard, for the 10 years leading up to 2007, the majority of actively-managed U.S. stock funds underperformed the index they were seeking to outperform. For instance, 84% of actively-managed U.S. large blend funds underperformed their index, and 68% of actively-managed U.S. small value funds underperformed, as well. The case is even worse for actively-managed bond funds. In that case, almost 95% of actively-managed bond funds underperformed their indexes for the 10 years leading up to 2007.· Furthermore, being consistent can be even more difficult for active fund managers.
For the period of December 31, 1992 to December 31, 2007, only 41.6% of actively-managed U.S. large company funds that beat the S&P 500 in a particular year were able to beat the S&P 500 in the next year. After three years, only 9.7% of the original group was still beating the index. The numbers are similar for actively-managed small cap funds and emerging market funds. Also, actively managed funds have higher management fees.
One has Higher Fees:
Actively-managed funds start at a disadvantage when compared to index funds. The average ongoing management expense of an actively-managed fund costs 1% more than its passively managed cousin. The expense issue is one reason why actively-managed funds underperform their index.
Another issue is that the portfolio manager of an actively-managed fund (who is in search of extra returns) buys and sells investments more frequently than an index fund. This buying and selling of stocks by the active manager (known as turnover) results in taxable capital gains to the fund shareholders, provided the fund is owned in a non-retirement account and it results in higher taxes for these fund investors.
The evidence shows that there are good active managers, but finding such managers in advance of their outperformance is difficult.· Therefore, those investors who decide to use index funds are likely to outperform most actively managed mutual funds (especially when the index funds lower fees are considered) while taking on lower risk, and tax obligations.