Mutual funds and exchange-traded funds (ETFs) let you own a diversified basket of securities in a single investment. Within those fund types there are two broad approaches. Index funds aim to match the performance of a market index. Actively managed funds aim to beat an index, or to achieve a specific goal, through the decisions of a manager or team. Understanding the difference helps you read fund documents and decide what fits your plan.
How index funds work
An index is a rule-based list of securities, such as a broad stock market index or a bond market index. An index fund holds the securities in that index, or a representative sample, in roughly the same proportions. When the index changes, the fund adjusts. The manager is not trying to pick winners, so the fund's return should closely track the index, minus fees and small tracking differences.
- Costs: index funds generally have lower expense ratios because they need less research and trade less.
- Transparency: you can usually see what the fund owns by looking at its index.
- Limitations: an index fund will fall when its market falls; it is not designed to sidestep declines.
How actively managed funds work
An active fund's managers choose which securities to buy and sell based on research, valuation views, economic outlooks or other strategies. They may concentrate on fewer holdings, change sector weights or hold more cash at times.
- Potential: active funds have the flexibility to differ from the market, which can help or hurt.
- Costs: they typically charge higher expense ratios, and higher trading activity can add costs that do not appear in the expense ratio.
- Manager risk: results depend on the skill and consistency of the people running the fund, and managers can change.
Comparing the two
Performance against a benchmark
Because active funds charge more, they need to outperform their benchmark by at least the cost difference just to match an index fund after fees. S&P Dow Jones Indices publishes regular SPIVA reports comparing active funds with their benchmarks across many categories, and those reports are a useful, independent reference. Past performance, whether of an index or a manager, does not guarantee future results.
Turnover and taxes
Turnover measures how much of a fund's portfolio is traded during a year. Higher turnover can lead to more taxable capital gains distributions for investors holding the fund in a taxable account. Index funds and many ETFs tend to have lower turnover, although this varies.
Risk
Neither approach removes market risk. A broad index fund spreads risk across many holdings; a narrow index fund or a concentrated active fund can be much more volatile. Read the fund's objective and principal risks in its prospectus.
Questions to ask before choosing
- What is the fund's objective, and which benchmark does it measure itself against?
- What is the expense ratio, and are there sales loads or other fees?
- How has the fund performed against its benchmark after fees over long periods, not just recently?
- What is its turnover, and will you hold it in a taxable or tax-advantaged account?
- Does it fill a role in your overall asset allocation, or does it duplicate what you already own?
Key takeaways
- Index funds aim to match an index at low cost; active funds aim to beat or differ from one at higher cost.
- Fees, turnover and taxes affect what you actually keep.
- Independent comparisons such as SPIVA reports and fund prospectuses are better guides than marketing claims.
- Choose funds based on how they fit your allocation and goals.
This article is general educational information, not investment, tax or legal advice, and it does not recommend any specific security or strategy. Check current details on Investor.gov (SEC) or FINRA, and consider speaking with a qualified, registered professional about your own situation.