What is an index fund and why is it better than an actively managed fund? An index fund is likely to outperform an actively managed fund 90% of the time. Plus, an index fund has reasonable expense ratios (fees), which makes a huge difference over time. For someone starting out, I’d advise you to choose an index fund over an actively managed mutual fund.
What is an index fund?
An index fund is a type of mutual fund constructed to track a part of the stock market. The word “index” refers to “passive investing.” The fund does not pay anyone to pick stocks. Instead, the fund replicates the performance of an index like the S&P 500. Because automatically tracking stocks does not require ongoing maintenance or decision-making, an index fund is much cheaper, as reflected in the expense ratio. Mutual funds charge expense ratios – that’s how they make money. A 1% expense ratio means the mutual fund will charge $100 every year for each $10,000 you put into the fund.
Why is an index fund better than an actively managed fund? Fees
Expense ratios are lower (cheaper) for an index fund than it is for an actively managed fund. The cost difference can be 10x or more (0.1% versus 1.0%). Imagine two identical funds with the same performance (rate of growth), but one charging a 0.1% expense ratio and the other charging a 1.0% expense ratio.
The chart below shows that while 0.1% and 1.0% may not seem like a huge difference at first, it can be a huge difference over time. Over the course of 20 years, the index fund will produce 21% more wealth than the actively managed fund. In 30 years, that gap becomes a 32% difference in money.
A big difference in expense ratios can erase any performance gains, too. In the chart below, we show that even if an actively managed fund consistently overperforms an index fund every year for the next 30 years (5.9% for active, 5.0% for index), the index fund with 10x less expense ratio will still create 3% to 5% more wealth.