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Index Funds vs. Actively Managed Funds: What’s the Difference?

Girl comparing index funds to actively managed funds

Index funds and actively managed funds are two popular investment options that let investors acquire an ownership interest in a large and typically well-diversified basket of securities with a single purchase. Funds of both types also simplify recordkeeping and distribution of dividends and capital gains while accommodating money-saving tax strategies. Beyond these similarities, however, they take very different approaches. Index funds are managed minimally, with managers seeking only to track the performance of a securities index. Actively managed funds, by contrast, aim to beat the market through skillful securities selection. A financial advisor can supply expert advice on specific index funds or actively managed funds that align with your goals.

Actively Managed Funds

Actively managed funds are overseen by a fund manager responsible for choosing specific securities to buy and sell. The manager’s goal is to use research and analysis to make decisions that generate superior returns. Actively managed funds often specialize in certain areas, such as small-cap stocks or international markets.

Because they are actively managed, these funds can adjust holdings based on market conditions. This can potentially allow them to outperform the market. Active managers may be able to identify underpriced stocks that are poised to deliver higher returns. Managers can also tailor the portfolio to meet specific investment goals and strategies, such as sector rotation or value investing.

In addition to these strengths, actively managed funds also carry drawbacks. For one, investors generally must absorb higher costs to pay for the managers’ work, for instance. And, despite managers’ best efforts, many actively managed funds do not consistently outperform, leading to unpredictable returns. Because performance depends on the manager’s skill and strategy, if either falters, returns are likely to suffer.

Index Funds

Girl calculating the potential return of index funds

Index funds operate under a very different philosophy. Rather than trying to beat the market, index fund managers seek only to match the performance of a specific index, such as the Nasdaq 100. They tend to hold securities for extended periods, with relatively little buying and selling. The approach is called passive investing.  

Index funds tend to have lower expense ratios than many funds because they require comparatively little research and trade relatively infrequently. Many index funds track broad indexes, such as the Nasdaq 500, so investors gain instant diversification by purchasing shares in them, reducing overall portfolio risk. Index funds also tend to produce consistent, predictable returns over long periods.

On the other hand, index funds offer limited flexibility, as managers are restricted to owning shares of companies that are members of the underlying index. Index funds can do little to respond to market changes or exploit opportunities represented by individual stocks. By their nature, index funds are unlikely to outperform the market and, in fact, typically slightly underperform the index they track due to the small but still real costs involved in running the fund.

Fitting Funds to Investors and Strategies

Index funds and actively managed funds can each play useful roles in a well-diversified investment portfolio. Many portfolios own both types of funds. However, certain investors and investment strategies may be better suited to one or the other.

Long-term investors seeking broad market exposure and consistent returns are often drawn to index funds. Investors who prioritize low costs, simplicity and a buy-and-hold approach also favor these funds. Inexperienced investors who lack the knowledge to evaluate and select active managers may feel comfortable with an index fund that simply tracks the market.

Investors who seek returns that out-pace the market frequently choose actively managed funds for their potential to generate an extra return from skill stock selection. These investors are willing to pay higher fees as well as put more time into monitoring the performance of the fund and its managers. Seasoned investors who enjoy researching investments and appreciate the skill and reputation of a specific fund manager may be attracted to these funds.

Bottom Line

Girl comparing actively managed funds to index funds

Index funds and actively managed funds offer significantly different investment approaches and cost structures as well as the potential for outperformance. Index funds give investors broad market exposure, low costs and stable returns, making them suitable for passive, long-term investors. Actively managed funds provide customization, active decision-making and potential for higher returns, appealing to investors who are willing to accept higher costs and actively manage their portfolios.

Tips for Investing

  • A financial advisor will assist you in determining the appropriate allocation of index funds and actively managed funds within your portfolio. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.

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