Active or Index Funds

Have you ever looked at a list of managed funds or ETFs and wondered why some charge higher fees than others? Often, it comes down to how the fund is managed. Some are actively managed, with professionals picking and choosing investments. Others simply track the market, these are known as index funds or passive investments.

So, is it worth paying more for active investment management? Let’s consider what each option is, why the debate exists, and what it could mean for your investment strategy.

Understanding the Two Investment Styles

What is Active Investing?

Active investing is when a fund manager (or an individual investor) actively makes decisions about what to buy, hold, or sell in a portfolio. They study the market, research companies, and aim to pick investments that will outperform the broader market.

Key features of active investing:

• A manager or team makes investment decisions based on analysis, research, and forecasts

• The goal is to beat the market or outperform a specific benchmark like the ASX 200 or S&P 500

• Active funds often have higher fees due to the resources involved—analysts, trading costs, and active management

What is Index (Passive) Investing?

Index or Passive investing is about following the market rather than trying to beat it. These funds aim to mirror a market index such as the ASX 200 in Australia or the S&P 500 in the U.S.

Key features of index investing:

• The fund holds the same companies, in the same proportions, as the chosen index

• It's more hands-off as changes to the portfolio usually happen when the index itself changes

• Fees are generally much lower because there’s no need for in-depth research or frequent trading

Why Has Index Investing Become So Popular?

Over the past two decades, index investing has grown significantly. Major investment companies like Vanguard and BlackRock now manage trillions of dollars globally through index funds and ETFs.

1. Lower Fees

One of the biggest appeals of index funds is the cost. Active fund managers charge more because they are actively researching and managing the fund. Index funds, by contrast, simply follow the market and cost much less to run.

Over time, even small fee differences can impact your investment returns.

2. Long-Term Performance

While active funds aim to beat the market, it’s not always easy to do so especially consistently. The SPIVA (S&P Index Versus Active) report regularly shows that many active managers underperform the index over the long term.

According to the SPIVA Australia Year-End 2024 Report:

• 55% of Australian General Equity funds underperformed the index in 2024.

• Over longer timeframes

  • 5 years: 73% underperformed

  • 10 years: 82% underperformed

  • 15 years: 85% underperformed

These stats highlight that while some active managers do outperform, many don’t especially once you factor in their higher fees to manage the investments.

Pros and Cons of Active Investing

Pros:

• Potential to outperform the market

• Flexibility to respond to market changes quickly

• Opportunity to focus on specific themes (e.g., ESG, small caps, income or undervalued stocks)

• May offer downside protection in falling markets if well-managed

Cons:

• Higher management fees

• Greater risk of underperformance

• Performance may depend heavily on the manager’s skill and decisions

• Can involve more frequent buying and selling, which may trigger tax consequences

Pros and Cons of Index Investing

Pros:

• Low fees and low-cost structure

• Simple, transparent, and easy to understand

• Historically, index funds have outperformed many actively managed funds over the long term

• Broad diversification (spreading your money across many companies and sectors)

Cons:

• No opportunity to outperform the market you’ll only ever match it

• No flexibility to avoid poorly performing companies in the index

• Exposure to all companies, regardless of ethical or ESG considerations

• May not suit investors looking for more tailored or thematic investing

But What If Everyone Chose Index Funds?

It’s a good question and an interesting one. Index funds rely on the market being active: they need prices set by people buying and selling shares based on company performance and expectations. If every investor only used index funds, price discovery could break down. Fortunately, active investors still play a vital role in ensuring markets function efficiently.

In other words, index investing works well in part because active investors still exist and keep the market moving.

Do You Have to Choose Just One?

Not at all. Many investors use a blended approach, combining the low-cost benefits of index funds with the potential for outperformance in specific sectors via active management. For example:

• Use index funds for large, diversified exposure

• Add active funds in areas where you want targeted exposure and ability to outperform

This mix can provide a balance of cost efficiency, diversification, and targeted opportunity.

Key Takeaways

• Active funds are managed by professionals aiming to outperform the market but often come with higher fees

• Index funds aim to match the market at a lower cost and have gained popularity due to their simplicity and efficiency

• There’s no one-size-fits-all answer many investors choose to combine both strategies

• Regardless of your approach, diversification and long-term focus are still some of the most important investment principles

Frequently Asked Questions (FAQs)

1. Are index funds safer than active funds?

No, both carry risks. Index funds will follow the market up and down. Active funds may perform differently based on the manager’s decisions, but this could either reduce or increase risk.

2. Do active funds always underperform?

No. Some active funds do outperform the market consistently especially in certain sectors or time periods.

3. Why are index fund fees so low?

Index funds are cheaper to run because they don’t require as much research or frequent trading. They simply follow a set index, which lowers the cost.

4. Can I invest in both types at once?

Yes. Many investors combine index funds and active funds in their portfolio to balance costs and performance potential.

5. Are ETFs and index funds the same thing?

ETFs (Exchange-Traded Funds) are often index funds, but not always. An ETF is a type of investment fund that trades on the stock exchange, some are passive (index-tracking), and others are actively managed.

When it comes to choosing between active and index funds, the right option depends on your goals, preferences, values, and interest in managing investments. Both styles have their place, and many investors find value in using a mix of both.

What matters most is starting early, staying diversified, and investing for the long term.

About Us

After working as an advisor for a decade, Joel founded Unified Wealth.

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