Investing Assets & Markets Mutual Funds Index Funds vs. Actively Managed Funds Index funds are smart choices for long-term investors By Kent Thune Kent Thune Twitter Kent Thune has spent more than two decades in the financial services industry and owns Atlantic Capital Investments, an investment advisory firm, in Hilton Head Island, South Carolina. He's written hundreds of articles for a range of outlets, including The Balance, Kiplinger, Marketwatch, and The Motley Fool. learn about our editorial policies Updated on January 21, 2022 Reviewed by JeFreda R. Brown Reviewed by JeFreda R. Brown Facebook Instagram Twitter JeFreda R. Brown is a financial consultant, Certified Financial Education Instructor, and researcher who has assisted thousands of clients over a more than two-decade career. She is the CEO of Xaris Financial Enterprises and a course facilitator for Cornell University. learn about our financial review board Share Tweet Pin Email In This Article View All In This Article What Is an Index Fund? What Is an Actively Managed Fund? Should You Own Index Funds? Active Management: Luck or Skill? Index Funds vs. Active Funds: Cost Tax-Efficiency Bottom Line Frequently Asked Questions (FAQs) Photo: Guido Mieth / DigitalVision / Getty Images The index funds versus actively managed funds debate should be engaging for every investor. Each type of mutual fund has its advantages and disadvantages. However, the best funds to buy will depend upon the individual investor's circumstances and investment objectives. Here's what to know about index funds versus actively managed funds. What Is an 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. Hundreds of market indexes can be invested in via mutual funds and exchange-traded funds. What Is an Actively Managed Fund? 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 to outperform the market index, like the S&P 500. Should You Own Index Funds or 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. After all, why settle for an index fund when you know you will only receive the market return, less a nominal fee to the fund’s manager? Unfortunately, evidence that actively managed funds can consistently outperform their relevant index is difficult to find. It’s even more challenging for an individual investor to identify which actively managed fund will outperform the index in a given year. According to Vanguard, in a study of index funds versus active funds, for the 10 years ending June 30, 2020, a total of 180 of 205 Vanguard funds outperformed their peer-group averages. 9 of 9 Vanguard money market funds57 of 66 Vanguard bond funds22 of 23 Vanguard balanced funds92 of 107 Vanguard stock funds Keep in mind, however, that most, not all, of Vanguard funds are index funds. Still, these results show the long-term advantage of passive investing versus active investing. Active Management: Luck or Skill? You might point out that some funds indeed beat their indexes, so why not buy those? How do we know whether the active manager was skilled in their investment selection or was just lucky? Evidence from a Barclays study shows that the chance for continued outperformance is slim for an active manager to continue beating the index. Index Funds vs. Active Funds: Cost 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. Index Funds vs. Active Funds: Tax-Efficiency Another issue, which is not reflected in fund return numbers, is that the portfolio manager of an actively managed fund—in search of higher returns—buys and sells investments more frequently than an index fund does. 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. Bottom Line As with any investment decision, the best type of fund to buy depends on the individual's circumstances and financial objectives. While history shows that there are good active managers, finding such managers in advance of their outperformance is difficult. Since index funds have historically beaten the majority actively managed funds for periods of 10 years or more, long-term investors should seriously consider passive investing. Frequently Asked Questions (FAQs) What are mutual funds? A mutual fund is an investment vehicle that pools funds from investors and buys a variety of securities. Mutual funds can buy stocks, bonds, and other assets. They can help investors diversify their portfolios and simplify their investment decisions. How do you invest in mutual funds? First, decide what mutual funds you'd like to invest in. Consider the minimum investment required, whether the fund is actively or passively managed, the expense ratio, and what the fund invests in. Once you decide which mutual funds appeal to you, open a brokerage account to invest in those funds. Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Vanguard. "Index Funds vs. Actively Managed Funds." Barclays. "The Science and Art of Manager Selection: Manager Research at Barclays," Page 6.