It's fairly difficult — even for professional investors — to consistently "beat the market." This realization led to the creation of index mutual funds, which are passively managed investment vehicles designed to match the performance of a particular market index by owning the same securities included in the index.
Today there are hundreds of indexes and index funds tracking various types of assets.1 Still, index funds are not the only game in town, and there is plenty of discussion in the financial media around whether investors are better off using passive or active investing strategies.
Source: The Wall Street Journal, November 29, 2018
According to Morningstar, just 38% of active U.S. funds outperformed their benchmarks during the 12 months ending in December 2018, and success rates are even lower over longer periods. Even so, active and passive funds tend to perform differently during different market cycles, and they may serve a variety of purposes in your portfolio.2
Here are some pros and cons associated with both types of mutual funds.
A passive approach
Many of the well-known, third-party indexes that are commonly tracked by index mutual funds are broad based and capitalization weighted. Thus, index investing traditionally involves buying all the securities in a market or market sector and weighting them based on their value in the marketplace.
Passively managed index funds have less managerial involvement, so fees are often lower than they are for actively managed funds. Index funds may also buy and sell assets less frequently, and lower turnover may help minimize distributions subject to the capital gains tax. Tax efficiency may be an important consideration when mutual funds are owned in taxable accounts.
The money flowing in and out of index funds has become a more powerful force in the financial markets, and it's possible that their structure may be distorting prices of the individual assets in the index. For example, when investors buy or sell shares of an index fund, all of the underlying companies are treated the same (rewarded or punished) whether they deserve it or not.3
A hands-on strategy
Active fund managers strive to outperform benchmarks by hand picking securities based on rigorous research and a defined investment strategy. Thus, an actively managed fund offers investors the chance to outperform the overall market, although most of them historically have not.
An actively managed mutual fund may be more diversified than an index fund holding stocks in the same asset category, simply because the performance of a market-weighted index can be dominated by a small number of the largest companies. Diversification is a method used to help manage investment risk; it does not guarantee a profit or protect against loss.
Active managers also have more flexibility and may use a variety of trading strategies to help manage risks. For these reasons, some actively managed funds may offer defensive benefits when markets are falling.
Declare a draw
There is no need to pick a side in the active-versus-passive debate. Depending on your goals and risk profile, there may be plenty of room in a well-diversified portfolio for both types of mutual funds.
The return and principal value of stocks and mutual funds fluctuate with changes in market conditions. Shares, when sold, may be worth more or less than their original cost. The performance of an unmanaged index is not indicative of the performance of any specific security. Individuals cannot invest directly in an index.
Mutual funds are sold by prospectus. Please consider the investment objectives, risks, charges, and expenses carefully before investing. The prospectus, which contains this and other information about the investment company, can be obtained from your financial professional. Be sure to read the prospectus carefully before deciding whether to invest.
3Bloomberg.com, December 4, 2018