Index funds vs actively managed funds: Which is better for you?

What are actively managed funds?

Actively managed mutual funds rely on professional fund managers who aim to outperform benchmarks through active security selection and trading. These funds differ from index funds by leveraging market research, analysis, and a hands-on approach to adjust portfolios dynamically. Fund managers may focus on undervalued opportunities, specific sectors, or regions with perceived growth potential.

For example, a fund manager might allocate a larger portion of the portfolio to technology stocks during periods of innovation or shift focus to defensive sectors during economic uncertainty. These strategies allow actively managed funds to respond to changing market conditions, offering the potential for returns above the benchmark.

However, actively managed funds often come with higher costs due to management fees and transaction expenses. While some investors value this approach for its ability to navigate complex markets, outcomes can vary widely, and higher costs may impact overall performance.

Actively managed funds appeal to those who prioritise customisation and are comfortable with higher fees in exchange for potential outperformance.

Differences between index funds and actively managed funds

Understanding the distinctions between index funds and actively managed funds is crucial for deciding which ones suit your investment profile. Here are the main ones:

Management style

Index funds adopt a passive strategy, focusing on replicating the composition of a market index with minimal trading. This contrasts with actively managed funds, where fund managers make dynamic decisions based on research, aiming to outperform benchmarks.

Costs

Index funds typically offer lower expense ratios, often ranging from 0.03% to 0.2%, because of their less intensive management. Actively managed funds, requiring more resources for analysis and trading, incur higher fees, often ranging from 0.5% to 1.5% or more.

Performance predictability

Index funds align with their benchmarks, providing predictable returns that mirror the market. Actively managed funds aim for higher returns but face variability depending on market conditions and the fund manager's decisions.

Risk profiles

Index funds expose investors to market risk, with performance tied to broader market movements. Actively managed funds, while introducing the potential for higher gains, also carry managerial risk, as outcomes depend on the strategy and timing of the fund manager.

Diversification

Index funds provide broad diversification by tracking large indices, covering a wide range of sectors and companies. Actively managed funds may focus on specific sectors, themes, or regions, offering targeted exposure but also concentrated risks.

Simplicity vs. customisation

Index funds are straightforward, aligning directly with their benchmark, making them easy to understand and manage. Actively managed funds allow for tailored strategies, appealing to those with specific goals or preferences.

How to build a balanced portfolio with both fund types

A well-balanced portfolio can integrate the strengths of index funds and actively managed funds to achieve both stability and targeted growth. This approach tailors investments to meet specific goals while managing risk effectively.

Use index funds as the foundation

Index funds provide the broad market exposure necessary for a stable portfolio core. Their low costs and passive nature make them ideal for long-term growth. For instance, allocating a significant portion to a total market or S&P 500 index fund ensures diversification while keeping fees low.

Add actively managed funds for specific goals

Actively managed funds can complement index funds by targeting sectors, regions, or strategies with higher growth potential. For example, an investor may include an actively managed fund focused on emerging markets or small-cap stocks, aiming to capture returns from less efficient or niche areas of the market.

Diversify and manage risk

While index funds reduce company-specific risk through broad diversification, actively managed funds may introduce concentrated exposure. Balancing these ensures that the portfolio benefits from active strategies, without becoming overly reliant on them.

For instance, combining an index fund covering the US stock market with an actively managed fund specialising in technology stocks offers a mix of stability and targeted opportunity.

Rebalance for long-term consistency

Periodic rebalancing is crucial to maintaining your desired allocation. Market movements can change the portfolio's weightings, potentially increasing risk or misaligning with your goals.

Rebalancing ensures that your portfolio stays on track, whether that means trimming gains from actively managed funds or increasing index fund holdings after a market downturn.

Example allocation strategy

A balanced portfolio might include:

• 70% index funds. Broad exposure to market benchmarks like the S&P 500 or global indexes.
• 20% actively managed funds. Targeted investments in sectors or strategies with higher potential returns.
• 10% fixed-income investments. Bonds or other low-risk assets for added stability.

Make sure you allocate your funds according to your individual investment preferences and risk tolerance.

What's the role of costs in fund performance?

The cost structure of both index funds and actively managed funds directly impacts their long-term returns. Index funds, with expense ratios as low as 0.03%, provide a cost-efficient way to achieve market returns. Actively managed funds, with fees ranging from 0.5% to 1.5% or more, require higher gross returns to offset these costs.

Here are two examples:

• Example 1. A fund with a 1% expense ratio must deliver an 8% return to match the net performance of a fund with a 0.2% expense ratio and a 7% gross return.
• Example 2. Over 20 years, a USD 100,000 investment in an index fund with a 0.2% expense ratio could grow to USD 372,756, while an equivalent investment in an actively managed fund with a 1% expense ratio might grow to USD 320,714.

The compounded effect of fees highlights the importance of cost efficiency, especially for long-term investors. However, actively managed funds can justify their higher costs when they successfully capitalise on market inefficiencies, or generate excess returns (alpha) through well-executed strategies

Conclusion: Costs shape long-term outcomes

The cost advantage of index funds often contributes to their tendency to outperform actively managed funds over the long term. Lower fees could allow more of your investment to compound, creating a significant edge in markets where active managers struggle to beat benchmarks consistently.

However, combining both index funds and actively managed funds in your portfolio can offer a steady foundation of broad market exposure alongside targeted opportunities for growth. Focusing on keeping costs low, and ensuring your investments match your goals, may also help you build a strategy designed for long-term success.