Passive or “index” funds are those that try to track/mimic, rather than outperform, the returns of a benchmark/index such as the Standard & Poor (S&P) 500 as closely as possible, purchasing all or a representative sample of its securities. In the case of actively managed funds, on the other hand, a manager makes specific investments with the objective of outperforming an index.
In 2016, actively managed funds comprised about 70%. However, an increasing amount of capital has been flowing into passively managed funds: In 2011, passive funds received $140 billion more than their active counterparts. In 2015, that number leaped to $576 billion.
Their relatively lower expenses are a major reason for passively managed funds’ rising popularity. Extensive research has also evidenced the largely disappointing performance of actively managed funds.
In 2015 the asset-weighted average expense ratio of passive (index) funds was 0.18%, but 0.78% for active funds, according to Morningstar. Note that asset-weighted averages reflect more accurately what investors pay than regular averages because they place more value on larger funds with more investors.
Why Are Index Funds Less Expensive?
Given that index funds only have to track an index and don’t require a large team of managers and analysts to make active decisions on how to invest, their typical lack of commissions and lower operating expenses is the major reason for their relative lower costs.
Secondly, historically index equity funds have concentrated their assets in large-cap U.S. indexes like the S&P 500, which are generally regarded to be lower in cost than managing portfolios of small- and mid-cap, international, and sector-specific stocks.
Further, index funds are typically much larger than their actively managed counterparts, which decreases expense ratios through economies of scale. While the average index equity (stock) fund held $5.1 billion in assets in 2015, the average actively managed mutual fund held $1.4 billion.
Per the S&P Indices Versus Active (SPIVA) 2016 Scorecard, 91.91% of large-cap actively managed mutual funds underperformed the S&P 500 index over a five-year period, and 84.62% over a one-year period. Mid- and small-cap actively managed mutual funds also did poorly, with 87.89% of mid-cap fund managers underperforming the S&P MidCap 400, and 88.77% of small-cap managers underperforming the S&P SmallCap 600, indices over a one-year period, also per the SPIVA Scorecard.
Therefore, it’s generally better to go with index funds, since they’re lower in fees and actively managed funds don’t tend to do better than market indices anyway.