Index Funds vs. Active Funds

Actively managed investments can make sense in certain market sectors, but broad market indexes largely outperform actively managed funds. In addition to the difficulty of picking stocks that consistently beat the market, active managers must overcome higher expenses and fees and generating more taxable income from trading. Most active fund managers cannot accomplish these feats consistently over longer periods of time. The headwind to beat the market while charging higher fees is too much to overcome.

Index funds are typically more tax-efficient than active funds because they don’t tend to change very much. The goal of an index fund is to mirror a broad market index, such as the S&P 500, and it doesn’t require much trading or turnover to do that. Active investments, on the other hand, aim to beat market indexes. Attempting to beat the market often involves more trading and investment turnover, which in turn can generate more taxes.

Index funds are also cheaper than actively managed funds, which makes sense. Active managers need to spend more time and energy managing their investments because they are trying to beat the market indexes. Index fund managers need to only mirror their index, which keeps costs down. 

The Investment Company Institute studies trends in mutual fund and ETF expenses, and their most recent annual report, released in March, found that index funds still have much lower expense ratios than their actively managed counterparts. The average expense ratio for index equity mutual funds (such as S&P 500 indexes) is 0.05%, and active equity mutual funds sit at 0.64%. That makes actively managed equity funds over 10x more expensive, on average, which is significant over a lifetime of investing. It is worth noting that while actively managed funds are still much more expensive, average active fund fees have dropped significantly over the past 20+ years.

Not only are actively managed funds more expensive and less tax-efficient, but they tend to underperform market indexes. Data from SPIVA finds, time and time again, that passive investments outperform active investments the majority of the time. 

In their most recent report, market indexes outperformed over 80% of active funds over the past 15 years in every single category of domestic funds that SPIVA tracks, from small-cap to large-cap to real estate. In some categories, over 90% of actively managed funds were outperformed by their respective benchmarks.

Is it possible that this trend could reverse and more active funds could outperform index funds? Sure, anything is possible. But there are no signs to indicate a reversal in this trend is imminent.

To beat the market, one would have to overcome the tax efficiency and low cost of index funds, in addition to picking an active fund that can consistently outperform its respective benchmark. While beating the market may be difficult, we know there are about 10% to 20% of active funds, depending on the market segment, that outperform their benchmarks. Can you simply invest in active funds that have a history of beating the market and expect continued success?

High-Flying Active Funds

There are certain actively managed funds that have outperformed indexes over long periods of time. Fidelity Contrafund is one such fund. This fund has managed to beat the S&P 500 by about 2% on average, annually, over the past 10 years. This alone is impressive, but even more impressive is the fact Contrafund has returned 13.15% average annually since inception in 1967, besting the S&P 500’s average return of 12.25% over the same period of time. If you invest in an active fund that has a long history of beating the market, can you expect that success to continue?

An analysis conducted a few years ago by a professor of finance at Yale, James Choi, sought to answer this question. Proponents of active funds often believe that past performance of a mutual fund can be indicative of, but does not guarantee, future success. This belief is based in part on a 1997 study that found past performance of actively managed funds does correlate with future success. When Choi extended this analysis to the present day, though, he found that to no longer be the case.

They found that from 1994 to 2018, a fund’s past performance was “completely unpredictive” of future returns. Choi went on to state that, “if anything, over the past two decades, you seem to do a little bit worse if you chase past returns on mutual funds.”

We like to make decisions based on data, and all of the data points towards index funds largely being better investments than active funds. They are less expensive to invest in, have less turnover if you are investing in a taxable account, and beat active funds around 80% to 90% of the time. Even if you do invest in the 10% to 20% of active funds that beat the market, the data tells us that those funds have no better chance of beating the market in the future than any other fund.

It is clear that index investing is one of the best ways to invest for retirement. It also happens to be one of the easiest ways to invest. You can invest in one fund, a target date index fund, and never have to worry about shifting your allocation over time or investing in other funds. Index funds aren’t flashy, but they have a long track record of helping Americans invest for their more beautiful tomorrow.

To build wealth in index funds, you need discipline, money, and time. It is easy to become a millionaire using index funds with all three ingredients but becoming one in 10 years means you have less time. Is it still possible?

Want to know what to do with your next dollar? You need this free download: the Financial Order of Operations. It’s our nine tried-and-true steps that will help you secure your financial future.

In this highlight, Casey seeks expert guidance on managing their Roth IRA investments while exploring the pros and cons of Target date index funds versus total market index funds. Unraveling the complexities of investing, the discussion emphasizes the power of personalized strategies based on one’s financial journey and risk tolerance, while uncovering the secrets to unlocking long-term wealth through early savings rates that outweigh the allure of high returns.

Want to know what to do with your next dollar? You need this free download: the Financial Order of Operations. It’s our nine tried-and-true steps that will help you secure your financial future.

In this highlight, Bo and Brian discuss weather a 529 or index funds is better for saving money for your child’s future college expenses.

Looking for a money multiplier calculator? Check out our Money Guy Wealth Multiplier to help ensure they that become a millionaire by 65!

If you do invest in individual stocks, keep it to no more than 5% of your investable portfolio. Here are a few reasons why we don’t think it’s a good idea to invest primarily in individual stocks.

1. You get emotionally attached. Your day-to-day mood becomes directly affected by the stock’s performance that day. When it’s up, you’re so happy, but, when it’s down, your mood is down, too.
2. You have the Financial Order of Operations out of order! By purchasing individual stocks, you are putting all of your eggs in one basket. You are focusing on the “get rich quick” rather than building wealth. The Financial Order of Operations (FOO) teaches nine tried-and-true steps that help you maximize your money and get on solid financial footing before trying individual stocks.
3. Success can still ruin you. Let’s say you buy an individual stock and you are right! If you double your money and sell, it’s a win! Right? What if the stock continues to go up after? The ideas of “what could have been” and “what might happen” can spur on overly risky behavior or continue to haunt you forever.

Check out the video below for information on different types of investments and which ones you should choose.

What happened at Vanguard?

Vanguard has two tiers of target date funds, one for individual investors and one for institutional investors, like large 401(k) plans. It is very common for large providers to offer different tiers of funds for different size investors. Like many large providers, the fees for the Vanguard institutional fund were lower than what is available to an individual investor. In late 2020, Vanguard lowered the minimum for institutional investors from $100 million to $5 million. At the time, expenses in individual funds were between 0.12% to 0.15%, and institutional expense ratios were 0.09%. This led to a large number of assets shifting to the less expensive institutional funds they now qualified for.

In February of 2022, Vanguard consolidated their target date fund lineup by merging its individual and institutional funds – and reducing expenses to 0.08% (a very slight reduction for institutional investors, and a 0.04% to 0.07% savings for individual investors).

For many individual investors, though, the damage was already done. When Vanguard lowered the institutional fund minimums from $100 million to $5 million in December of 2020, those that now qualified for funds with lower expense ratios started redeeming individual shares and moving to institutional funds. Vanguard sold as much as 15% of their assets in individual funds to raise cash to redeem shares. This realized a much larger than normal amount of capital gains, which were distributed to the funds’ remaining investors. According to a lawsuit filed against Vanguard, individual fund investors received capital gains distributions at least 40 times larger than ever before.

The impact of a large capital gains distribution

So what does this actually mean for regular investors? If you owned Vanguard individual target date funds in a tax-advantaged account, like an IRA, you would not have any tax consequences since these accounts grow tax-free. Mutual fund capital gains distributions only have tax consequences for those holding in a taxable account, such as a brokerage account. Additionally, tax consequences would only be significant if you had a large amount invested in a taxable account. For Vanguard’s 2040 fund, distributions in 2021 were 18%. Someone with $5,000 invested would have received a $900 distribution, and someone with $500,000 invested received a $90,000 distribution.

Assuming the smaller investor has a 15% capital gains tax rate, they would owe $135 in taxes on their unexpected distribution. If the larger investor has a 23.8% total tax rate on the distribution, they would owe $21,420 in taxes on the capital gains distribution. The unexpected Vanguard distribution could have had a big impact if you held a large amount of assets in a target date index (in a taxable account), but otherwise may not have had a large impact. If you do have a larger portfolio, though, and a large amount in a taxable investment account, how do you ensure something like this doesn’t happen?

How can you avoid an unexpected tax bomb?

If you haven’t yet reached a critical mass where a more personalized portfolio makes sense, you may not have a significant amount accumulated in a taxable brokerage account. Earlier steps of the Financial Order of Operations include maximizing a Roth IRA, HSA, and employer-sponsored retirement accounts. When someone does reach a critical mass where it may make sense to hire a financial advisor, the bulk of their assets are likely in tax-advantaged accounts.

Tax location is just one aspect of your finances a fee-only, fiduciary financial advisor can assist you with. If your portfolio has reached the point where you have a large taxable brokerage account, investing in mutual funds that may not always be tax-efficient could leave you with a surprise tax bill of thousands of dollars. If you have a larger portfolio, and a large taxable account, it is very important to pay attention to the location of your assets.

High-flying growth assets, like equity mutual funds, can make sense in a tax-free account such as a Roth IRA or HSA. Since the growth and distributions from tax-free accounts are entirely tax-free, if taken as qualified distributions, getting as much growth as possible out of these accounts maximizes your tax benefit. In pre-tax accounts, like a traditional 401(k), you may hold assets that generate ordinary income, non-qualified dividends, or other assets that may not necessarily be the most tax-efficient. All qualified pre-tax distributions are treated the same, no matter what assets are inside the account, so sticking less tax-efficient assets in a pre-tax account is worth considering. For your taxable bucket, such as a taxable brokerage account, it is very important to consider the tax-efficiency of assets held in the account. Tax-efficient assets could include ETFs, municipal bonds, or tax-efficient mutual funds.

I don’t fully understand tax location. Now what?

Tax location isn’t always easy for investors to master, especially if you don’t have a background in finance. The good news is you don’t have to do it alone. If your portfolio has reached a critical mass, which generally can happen as you cross the $500k threshold in invested assets, it may be time to consider working with a financial advisor. Feeling that you don’t have enough hours in the day, that you aren’t as confident in your financial decision making, or that you don’t know if you are doing everything you should be are just a few signs it may be time to consider bringing on a co-pilot.

For those that are thinking about hiring an advisor, or already talking to potential advisors, we created a resource for you: “8 Questions to Ask Your Financial Advisor.” It can be difficult to know what to look for in an advisor if you aren’t in the financial world. Asking the right questions can help determine if a financial advisor is a good fit for you and if they will truly have your best interests at heart.

Too often, “investment management” gets mistaken for “financial planning.” Investment management includes managing a portfolio, asset allocation, asset location, and strategies like tax-loss harvesting, but a fee-only financial advisor can help with so much more. Financial planning includes all of the above, and insurance planning, estate planning, tax planning, cash flow management, college planning, retirement planning, and any other financial questions you may have. You can learn more about our day job as a fee-only financial advisory firm, and submit a “Work With Us” form, on our website.