Should you try to beat the market, or simply own it? Here’s the difference between index funds and actively managed funds, and why the debate between them comes down to fees.
When you invest in a managed fund, an exchange-traded fund or a super fund’s investment option, your money is managed in one of two main ways: passively or actively.
Index funds
An index fund, also called a passive fund, aims to match the return of a market index rather than beat it. An ASX 200 index fund, for example, owns shares in the 200 companies in that index, in the same proportions.
Because there’s no team of analysts picking shares, index funds are cheap to run. Fees on some of the biggest are a small fraction of 1% a year.
The idea was popularised by American investor John Bogle, who founded Vanguard and launched one of the first index funds for ordinary investors in 1976.
Active funds
An active fund employs professional fund managers to choose which shares, bonds or other assets to buy and sell, aiming to beat the market.
Active managers may avoid companies they think are overvalued, focus on those they think will grow, or move money into cash when they expect markets to fall.
Some succeed, at least for a time. But research, including regular studies by S&P Dow Jones Indices, has found the majority of active funds in Australia and the U.S. underperform their benchmark index over periods of 10 years or more, once fees are taken into account.
Why fees matter
The difference in fees can seem small, perhaps 1% a year. But because of compounding, that gap can add up to tens of thousands of dollars over decades.
Active funds have to beat the market by more than their extra fees just to break even with a cheaper index fund.
Which is better?
Supporters of index investing argue it’s simple, cheap and, for most people, delivers better results over time.
Supporters of active management argue skilled managers can add value in some markets, such as smaller companies, and can protect investors in downturns. They also point out that if everyone simply tracked the index, nobody would be checking whether companies are fairly priced.
Many investors and super funds use a mix of both. Index funds have grown rapidly in popularity, especially through exchange-traded funds listed on the ASX, which let investors buy a whole market in a single trade.
Whichever approach you choose, it’s worth checking the fees you’re paying, including in your super.
