Most Index Funds Outperform Managed Funds Because of Efficient Investment Approach

Most index funds outperform managed funds because of their efficient investment approach. This is due to the fact that index funds track a specific market index, such as the S&P 500, which provides broad diversification and reduces the need for active management.

Index funds have lower fees compared to managed funds, which can eat into returns. According to data, the average expense ratio for an index fund is around 0.2%, while managed funds can have expense ratios of 1% or more.

Research has shown that the majority of actively managed funds fail to beat the market over the long term. A study found that only about 4% of actively managed funds outperformed the S&P 500 over a 10-year period.

Explore further: Emerging Market Index Funds

Index funds have a lower turnover rate, which means they don't buy and sell securities as frequently as actively managed funds.

This reduced activity leads to lower trading costs and less tax liability for investors.

Actively managed funds, on the other hand, have a higher turnover rate due to their attempt to time the market and pick winning stocks.

Lower trading costs and tax liabilities can add up to significant savings for index fund investors.

The evidence shows that index funds outperform actively managed funds over the long term, with some studies suggesting a 2% annual difference in returns.

Performance Comparison is a crucial aspect of evaluating mutual funds. I check out its performance measures, which include average annual returns over various time frames and in comparison with indexes.

To beat the market, I'd want the annual investment returns to exceed the returns of their benchmarks. For example, I'd compare a small-cap fund with the performance of the Russell 2000, which represents small caps.

The SPIVA scorecard shows that a significant percentage of actively managed funds underperform their respective indexes. Specifically, 66.11% of large-cap managers, 56.81% of mid-cap managers, and 72.2% of small-cap managers underperformed the S&P 500, the S&P MidCap 400, and the S&P SmallCap 600, respectively.

Recommended read: Equal Weighted S&p 500 Index Etf

Funds have trading and operational costs, which can lead to underperformance compared to indexes. For instance, Vanguard 500 Index Fund Admiral Shares (with an expense ratio of .05%) lags S&P 500 performance by .01-.04% over various timeframes.

Here's a summary of the performance differences between index funds and actively managed funds:

It's worth noting that even index funds may lag their respective benchmarks due to trading and operational costs.

Actively managed funds underperform because their stated objective and strategy don't always perform well. For instance, a fund focused on the health care sector will do well when the sector is booming, but poorly when it's struggling.

Fidelity's Select Health Care Portfolio is a prime example of this. Over the past 10 years, it beat the S&P 500 and the health sector in general when the sector was performing well, but fared poorly when it wasn't.

Fund managers are human, prone to human emotion and error, which can lead to poor investment decisions. This risk is all but removed with index funds, where investments are based on a selection of well-performing investments, not chosen by one person.

A fresh viewpoint: Managed Care

Even an experienced fund manager with skill, knowledge, and nerves of steel can't get past the unpredictable nature of the stock market.

Management expenses play a significant role in the underperformance of actively managed funds. Index fund expense ratios averaged 0.06% in 2020, whereas actively managed mutual funds had expenses of around 0.71% or higher.

This means that index fund investors can begin each year with a 0.67% headstart on actively managed funds, making it harder for active fund managers to beat index funds over long periods of time.

Fees matter, and they're one of the only reliable predictors of success. According to Ben Johnson, director of global ETF research for Morningstar, lower-cost funds had greater odds of success.

The cheapest active funds outperformed about twice as often as the most expensive ones, 35% versus 18%, in the decade through Dec. 31, 2021. This is a significant difference, and it highlights the importance of considering fees when choosing a fund.

The average asset-weighted fee for an index fund was 0.12% in 2020, whereas the average active fund had a fee of 0.62%. This means the average active fund needs to earn an extra 0.5% to equal the return of the average index fund.

Index fund expense ratios averaged 0.06% in 2020, while actively managed mutual funds had expenses of around 0.71% or higher. This 0.67% headstart on actively managed funds makes it harder for active fund managers to beat index funds over long periods.

Investors should be aware that actively managed funds have higher expenses than passively managed funds or index funds. The expense ratio of the Vanguard Strategic Small-Cap Equity Fund is 0.34% compared to 0.08% with the Vanguard Small-Cap Index Fund (Admiral Shares).

For another approach, see: Vanguard Mid Cap Funds

Passive investing is a game-changer for those looking to simplify their investment strategy. By choosing index funds, investors can significantly reduce the time and effort spent selecting individual investments.

According to the SPIVA Statistics & Reports, active funds are more likely to see changes according to trends, making them less stable than index funds.

Here are some key statistics that highlight the benefits of index funds:

Investors who opt for index funds can also avoid the extra fees associated with actively managed funds.