Ask MAX: What's better: an index fund or an actively managed fund?

March 21, 2004

Dear MAX,

What's better: an index fund or an actively managed fund?

Sarasota, FL

Dear Blanche,

Can't we all just get along?

The rivalry that exists between active fund people and index fund people is a long and bitter one, and has been growing in intensity ever since Vanguard's John Bogle launched the first index fund, the Vanguard 500 Index Fund (VFINX), back in 1976. Supporters of index funds think active fund owners are suckers who pay higher fees for worse performance. Active fund owners consider index fund owners over-diversified, risk-averse wimps.

I want to be very careful here, Blanche. Because of the highly controversial nature of your question and the potential for harm an incomplete answer could cause on one side or the other, I'm going make sure to respond to it as carefully and completely as I can.

An index fund is a mutual fund that tries to mimic, as closely as possible, the holdings of a particular index. Depending on the fund, the index tracked might be the S&P 500 Index, the Dow Jones Industrial Average, the Wilshire 5000 Equity Index, the NASDAQ Composite Index, or any one of the scores of other indexes that have sprung up over the years.

An actively managed mutual fund doesn't follow an index. Active managers build their funds one company at a time, through painstaking research and analysis. The job of an active fund manager is to identify and buy the very best stocks that fit their fund's prospectus objective.

Both actively managed and index funds have aspects to them that are good, and aspects that are not so good. In our MAXadvisor Newsletter model portfolios we invest in both index and actively managed funds. Which one is 'better' depends on who it is that is buying the fund, what that person hopes to achieve with the money they place in the fund, and even the markets conditions that exist during the life of the investment.

Advantage Index Funds

Expense Ratio - The one thing supporters of index funds cite as being the single biggest advantage index funds have over actively managed funds is their cost of ownership. Index funds are almost always cheaper to own than actively managed funds.

Why? Because essentially all the manager of an index fund does is check the paper each morning and make sure that their fund owns the same stocks in the same percentages as the underlying index. If the index has added a new company, the manager buys shares of the new company and adds them to the fund's portfolio. If the index has dropped a company, the manager sells the shares of that company that their fund owns.

Because index fund managers don't really make any decisions about which stocks to buy or sell, index funds are said to be passively managed. And because index fund managers don't have to spend any money researching potential investments, the expenses of index funds are generally pretty low.

Portfolio managers of actively managed funds have to spend a lot more money (and work a whole lot harder) than passive managers to determine which stocks to buy and sell, and many of them get paid a lot of money (some too much money) for thier trouble.

You might not realize it, but investment research is an expensive, time-consuming process. Good fund managers buy a lot of very pricey research material. They employ large research staffs. They take a lot of trips, meet a lot of CEOs and, tour a lot of factories. Because of the money actively managed funds have to shell out on research each year that passively managed funds don't, the expense ratio of actively managed funds are generally higher than those of index funds.

The average index fund charges an expense ratio of .67% a year, while the average domestic equity fund (excluding index funds) charges 1.48%. While the difference might not seem like that much, over the years the money you save on expense ratios by investing in an index fund can really add up.

Turnover Ratio - Expense ratios aren't the only place where index funds save you money. Because of their low turnover ratio, index funds usually produce little or no capital gains distributions. Taxes paid on capital gains distributions are a hidden fee that most people don't think about when assessing the performance of a mutual fund they're considering investing in.

Knowing Exactly What You're Investing In - When you buy shares of an actively managed fund, you have a general idea of the kind of company the fund manager is supposed to invest in, but usually not what the exact companies in the portfolio are. Sometimes active managers stray from their stated investment strategies, succumbing to what is known as 'style drift.'

Owners of most index funds can find out exactly what companies they are invested in by checking the holdings of the index their fund tracks by looking in the newspaper or on the Internet.

Eliminates Bad Managers - Index fund managers make no decisions concerning what stocks they buy or sell. They come in each morning, check the data to make sure no new company has been added to their index, do a little rebalancing, make a few calls, have lunch, go home. That's about it.

Index fund managers never make a big bet on a risky investment because it's getting close to bonus time and they need to stoke their fund's returns. They don't buy a crappy stock because they're too lazy to find anything better. They don't drive a fund into the ground because they simply don't know what the hell they're doing. Index funds, for the most part, take the manager out of the equation, which protects your money from mistakes and incompetent portfolio managers.

Diversification - What will the next hot sector be? Are Internet funds poised for a comeback? Will small cap funds continue to outperform other types of funds? Who knows?

Most popular index funds invest in a broad market. When you invest in an index fund you're usually not making a bet on a specific industry or sector, but are investing in the market as a whole. You don't have to worry about picking "the right" portion of the market to invest in, because you're investing in almost the entire thing.

Performance - The lower a mutual fund's management fee, the more money that fund has at work for investors. Because index funds on average have lower fees than actively managed funds, over a long period of time the universe of index funds tends to outperform the universe of actively managed funds.

Advantage Actively Managed Funds

Performance - Index funds usually give investors slow and steady performance. Investors in traditional index funds won't get really creamed, but will never have a huge performance year, either. Index funds usually do not show up at the top of the "best performing funds of the year" list. Index fund investors are hoping to make a nice, solid, average return. (Note: some index funds track narrow, sector specific indexes. These funds differ significantly from traditional index funds in terms of risk and potential return.)

But who wants to be average? Actively managed funds give investors a chance for so much more. If you build a portfolio of good actively managed funds, you should get much better performance than you could with a portfolio of index funds. Of course actively managed funds can fall a lot farther than index funds, too.

Index fund proponents say that the lower expense ratios most index funds charge make index funds, over a 10-15 year period, difficult to beat, and they have a good point. But what if your investing time horizon is less than 10 or 15 years?

Lower expense ratios make a big difference over time as the money investors save appreciates exponentially, but in the short term, say 5 years or less, the benefits of appreciation aren't that substantial. The increased performance numbers that actively managed funds put up in a good year should more than compensate for a reasonably higher expense ratio.

Expert Management - Like I said in part one of your answer, it doesn't take a whole lot to be the manager of an index fund. All index fund managers have to do is make sure their funds own the same stocks, in the correct percentages, as the underlying index. They don't do any research or make decisions as to what stocks their fund buys or sells. Whatever education, experience and training the manager of an index fund has is not really utilized. If the manager of an index fund learns that one of the stock her fund owns is about to tank, they can't sell unless the index drops it first.

Actively managed fund managers can buy whatever great stock they want, as long as it fits with their funds stated investment strategy (and, unfortunately, sometimes even if it doesn't). They don't have to buy whatever it is some index tells them too, but are free to purchase whatever stocks they think have the best chance of performing well.

Actively managed funds benefit from the expertise of good managers. An active fund a manager who knows what she's doing can usually trounce the returns of an index fund.

So Which is Better?

Sorry to say it, there is no easy answer to the question. Like I outlined above, both have distinct advantages and disadvantages. Its our opinion that investors will do better over time investing in well-chosen low-fee actively managed funds, but picking good actively managed funds takes a little work.

If you're an investor who wants to park your money in an investment and forget about it for 20 years, a good old S&P 500 or Wilshire 5000 index fund is probably a good choice for you. If you're looking for a shorter term investment, don't mind a little risk, and think you're knowledgeable enough to be able to recognize a good mutual fund, I think you'd be better off investing in an actively managed fund.


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