Why Index Funds Beat Actively Managed Funds

The financial media has a vested interest in portraying investing to be an especially difficult task, and they do a pretty good job of it.  But deciding between various types of investments you should buy to build a strong and diversified portfolio should not be based on some flashy advertisement. Is it better to invest in actively managed mutual funds or is it wiser to invest in index funds? The financial media would have you believe actively managed funds are the key to investment riches, but there is strong evidence that index funds are by far the better buy.

Investors looking to get more bang for their buck should consider ditching actively management funds for a diversified portfolio of low cost index funds. By avoiding the higher costs of the managed funds, investors in index funds can benefit from higher returns.

The Source Of Active Management’s Disadvantages

Actively managed funds seek to earn superior returns by strategically buying and selling stocks at the most opportune times.  Because active managed requires a lot of research into hundreds of different companies, sectors, and insight into broad economic trends, they tend to carry hefty price tags.  After all, an office full of trained analysts isn’t cheap.  Because of this, actively managed funds are often  four, six, and even eight times the cost of a comparable index fund.  The practical consequence of higher costs is that most actively managed funds must outperform the index by 1-2% year in and year out just to overcome their expense handicap.  As it turns out, this is extraordinarily difficult to do.  Very, very few mutual funds ever manage it.

Index Funds – It’s What’s For Dinner

Instead of trying to beat the market, the goal of an index fund is merely to track a specific index. The index fund simply purchases all the securities in the same proportion as the index it follows (within reason) rather than attempting to beat it via savvy stock picking.  Index funds exist that track a variety of indexes such as the S&P 500 index, Lehman Aggregate Bond Index, and literally dozens of others in almost every conceivable asset class.  Because you don’t need an army of analysts or hot-shot mutual fund managers to track an index, index funds tend to have rock-bottom expenses.

Choosing Index Funds Over Managed Funds

The benefit of investing in index funds over their actively managed counterparts should by this point be obvious:  lower costs.   Many domestic actively managed funds charge in excess of 1.5% per annum whereas index funds typically top out at 0.3% (slightly higher for more exotic asset classes like international small cap or emerging market funds).

Why Index Funds Are Better

The stock market is an intensely-competitive place.  Fund managers have a tough time even matching the performance of their relevant index, much less outperforming it. While plenty of managers may be successful in any given year, very few manage it consistently over time. Many studies show that most actively managed funds will not outperform their benchmark index.  In fact, most actively managed funds tend to under-perform the index by the amount of their expense ratio, further proof that investment costs matter.