Index vs Active Investing: Making the Smart Choice — Wealth in Yourself (2024)

Index vs Active Investing: The Age Old Debate

If you follow financial planning then you’ve probably heard this argument before. Hopefully, this article helps you feel more confident in how you approach investing. If you’re new to this discussion let me catch you up to speed.

Index funds are a way to buy a lot of companies all wrapped into one “fund”. You can buy indexes that are groupings of large companies, small companies, only tech companies, etc. When you buy that index you own a small portion of all of the companies within it and that fund will always be that grouping or index of companies. As an example, you could buy the S&P 500 Index which would be the grouping of most of the largest 500 companies in the U.S. As time went on companies can come and go, but unless that happens the index will be comprised of the same companies weighted by their value.

An active fund example would be when a fund manager takes the grouping of the largest 500 companies, eliminates some, gives a larger share to specific companies, and tries to outperform the original index. In short, they are trying to predict which companies will do better than others. This can be done for any index and funds are created that don’t adhere to an index at all, essentially a collection of the fund manager's favorite stocks at that time. They can make as many trades and adjustments as they’d like in order to make them perform as well as they can.

Typically when you hear a really passionate argument on either end of the spectrum it’s because they make money in some way from the additional sales of those funds. I wanted to give a third-party perspective since I don’t have a horse in this race. Just like any investment your objective and time horizon plays a part in your decision, so I’ll try to stick to the facts and let you decide for yourself.

· Over a 10-Year Period: 90.03% of Large Cap Funds Underperformed the S&P 500

This data was from June 30th, 2022 but this has been the story for quite some time. The SPIVA research is meant to measure actively managed funds against their benchmarks and they’ve been doing it for over 15 years. If you were wondering if Small-Cap funds did any better, they did not. 91.36% underperformed over the last 10 years based on that same data from June. Over shorter periods of time, it becomes closer to a 55/45 chance with the odds still against you. Don’t take my word for it, go click the link and look at the data yourself. While you’re there make sure to read the persistence scorecard. This is essentially an illustration through data that “regardless of asset class or style focus, active management outperformance is typically short-lived” (Berlinda Liu). If you don’t have time to check it out here’s a data point.

· 55.5% of all domestic funds that were in the top quarter in terms of performance in 2019 were able to do it again in 2020. By 2021, 2.2% of those funds were still performing in the top 25%.

In other words, a little over half of the fund managers were able to repeat their top-performing years but about 2 out of every 100 were able to do it three years in a row. The amount of money, time, and resources that go into extremely smart and talented people trying 40 hours a week to beat the market is breathtaking. Yet it is still a major financial product, it’s human nature to think we know something others don’t, to feel ahead of the curve.

This is how we overweight areas of our portfolios unintentionally, we feel really good about an investment choice and put more into it than other investments and our mix in the portfolio becomes unbalanced and way too reliant on that favorite area. I think actively managed funds will always play a part in our investment universe, but I don’t see them ever going away because we all keep buying them! I’ve done it and you probably have too, and sometimes if you have a short time horizon you may come out on top and that feels so good, it’s the reason we keep doing it. The reward is the feeling of “beating” the market. For the majority of us who are investing for the long term, just stick to index funds as part of your larger portfolio strategy.

Don’t forget how important it is to have a diversified portfolio, this article in no way is saying to put everything in one index. A portfolio still needs to be rebalanced, there is still a degree of active management you can do if you’d like to follow strict ESG principles, overweight sectors or asset classes, or tilt towards value or growth type investments. This can all be done using low-cost index funds and you’ll be surprised at how much you save in expenses over the long run.

According to the Investment Company Institute, the average expense ratio for actively managed stock funds in 2021 was .68% compared to .06% so over 11 times higher. Let’s put that into context, here are some numbers for a million-dollar portfolio

1 Year: .06% = $600

1 Year: .68% = $6,800

Another way to think about this is that when you are in an actively managed fund you not only need to match the index but you actually need to beat it by the expense ratio (.68% or $6,200 in this example) in order to match the performance of the index. Over time the snowball effect of not having fees erode your performance makes it really tough to make a case for using actively managed funds.

Warning: “Direct indexing, custom indexing, personalized indexing” is active management in a cheap suit. This is a story for another day but know that they are two different things entirely.

Typically this is where I say “Want to see more content like this?”, or “Have a different perspective, reach out” but in this case, it’s not necessary. This “argument” has been a moot point for a decade, if you’re advisor is still blowing the actively managed funds horn it may be time to seek out another perspective. If you want to get a second opinion my calendar is below.