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Active VS. Index Mutual Funds

Active VS. Index Mutual Funds

July 06, 2022

Whether at a cocktail party or talking with your uncle on vacation, it isn’t uncommon to hear the terms “active” and “indexed” thrown around when discussing investment portfolios. Both of these may even be methods you’ve followed yourself.

After a quick google search, you may be asking yourself, “why would I want someone passively managing my investments? Wouldn’t it be prudent to have an active investment manager constantly monitoring my piece of the pie?” Let’s break that down.

The terms active and passive refer to the management style of the fund manager. Typically, active fund managers will spend a lot more time on a day-to-day basis focused on the holdings in their portfolio. They will be looking for that day’s winners and losers, using technical analysis to plan their buy and sell investment actions for a (hopefully) winning outcome.

A passive fund manager is going to do the opposite of an active fund manager. Actually, most of the time, there isn’t an actual human being behind the fund at all. Most fund companies will have a computer tracking the index, with a fund “manager” to oversee and ensure everything is working correctly.

While the passive fund may seem a bit boring and rudimentary, there are some benefits to these index funds.

They have lower expense ratios. Since there is not much work going into the investment decisions, there’s no reason to charge higher fees. To that point, the entire goal of an index fund is to track the index and provide results very similar to what that market index is doing.

The goal of index funds, when it comes to expense ratios, is to have the net return be as close to the actual index as possible.

Active funds take a different path. For those chasing more than what the market offers, active mutual funds strive to perform above and beyond what the actual market is doing. They charge higher expense ratios, which is warranted due to the fund’s active, day-to-day management by a fund manager and their team. Active funds are not guaranteed, by any means, to perform better than the market, but that is undoubtedly the goal.

The most significant difference between active vs. index is the style. When choosing which type of fund to pursue, an investor should always think about:

    1. Their Goal

    2. Their Tolerance of Risk (above and beyond the indexes themselves)

    3. Their Cost Point

It is also important to remember that the expense ratios are not charged from the account holder’s balance but instead extracted from the fund’s performance. As an example, if a mutual fund returns 8% in a given year, and the expense ratio is .50%, then the investor would realistically see a return of around 7.5% that year. The fees are collected through the Net Asset Value (NAV), the price at which the mutual fund is bought and sold on the open market.

At MWA, we use both strategies in our clients portfolios. Our core equity positions are made up of index funds. This allows us to simply follow the market in a portion of the portfolio. Our growth and value positions are primarily active funds. This allows us to take advantage of the opportunities that a changing market supplies. The key with decision-makers should always be the goal of the portfolio, and what you and your team of financial professionals think is going to complement that the most.

It is not possible to invest directly in any index. Investing involves risk, and investors may incur a profit or loss.