Index funds vs. actively managed funds: how they differ

Most mutual funds and exchange-traded funds (ETFs) fall into one of two groups. Index funds aim to match a market index. Actively managed funds rely on a manager to decide what to buy and sell. This post describes how the two are structured and what they cost. It does not address which performs better, and it does not suggest that either is the right choice for any particular person.

What an index is

A market index measures the performance of a group of securities that is meant to represent a market or a part of one: large companies, small companies, a country's bond market, a single industry.

An index is a measurement, not an investment. As the SEC's page on index funds puts it, no one can invest directly in an index. An index fund offers an indirect way to do so.

How an index fund works

An index fund seeks to track the returns of its chosen index. It can do that in two main ways.

• Full replication. The fund buys every security in the index, in the same proportions.
• Sampling. The fund buys a representative portion of the index. This is common when an index contains thousands of securities or some that are hard to trade.

How the index weights its members matters. Many indexes are weighted by market capitalization, which is a company's share price multiplied by its number of shares. In such an index, the largest companies make up the largest share, so a fund tracking it holds more of them.

Index funds generally follow a passive approach. The manager is not deciding which securities are attractive. The portfolio changes mainly when the index changes.

How an actively managed fund works

An actively managed fund is not tied to an index. According to the SEC's overview of mutual funds, its adviser buys and sells investments in pursuit of a stated investment objective, and those trades must be consistent with the objective and strategies described in the fund's prospectus.

Active funds vary widely in how many securities they hold, how often they trade and what they are trying to achieve.

Structural differences side by side

Why costs tend to differ

Managing an active fund involves analysts, research and portfolio managers, all of which the fund pays for through its management fee. An index fund does not need that work, which, in the SEC's words, could mean lower overall costs to shareholders.

Less frequent trading also plays a part. Each trade a fund makes carries a transaction cost. In a taxable account, a fund's sales of appreciated holdings can also produce capital gains distributions that shareholders owe tax on. That tax point generally does not apply while a fund is held inside a 401(k) or IRA.

The SEC adds an important qualifier: not all index funds have lower costs than actively managed funds. Costs vary within both groups, so the label alone does not settle the question. The figure to compare is each fund's expense ratio, explained in fund fees and expense ratios.

Risks specific to each type

Index funds

The SEC lists several.

• Lack of flexibility. An index fund generally keeps holding what is in its index. It may have less ability than other funds to react when prices of those securities fall.
• Tracking error. A fund may not match its index exactly, especially if it uses sampling.
• Trailing the index. Because the index has no costs and the fund does, a fund may return somewhat less than the index it follows.

An index fund is also only as broad as its index. A fund tracking a single industry is an index fund, yet it is concentrated. See diversification explained.

Actively managed funds

• Manager risk. The SEC notes that an actively managed fund has the potential to outperform its benchmark, and that its performance is heavily dependent on the skill of the manager. The manager's choices can also leave the fund behind its benchmark.
• Cost as a hurdle. The SEC's bulletin on fund fees notes that a fund with higher costs must perform better than a lower-cost fund to generate the same returns for investors.

Both types share the general risks of whatever they invest in. A stock fund of either kind can lose value when stock prices fall.

The line between the two groups is not always sharp. Some funds track custom-built indexes, and the SEC describes these "non-traditional" index funds as using more complex or targeted strategies than have traditionally been associated with index funds. A target-date fund may be built from index funds, active funds or both.

What to read before choosing either

The SEC suggests asking the following about any fund.

• What fees and expenses apply to buying, owning and selling it?
• What specific risks does it carry?
• For an index fund, how is the makeup of the index determined?
• How does the fund's strategy fit with the investor's own goals?

The answers are in the fund's prospectus and most recent shareholder report. Past performance figures appear there as well, and the SEC's caution applies to both kinds of fund: past performance does not predict future returns.