Active or Index Funds: Which option suits you best?

Have you ever browsed through a selection of managed funds and noticed how some offer significantly lower fees? Typically, the funds with the reduced fees are known as index funds or passive funds.

Over recent years, the popularity of index investing has surged, with major entities like Vanguard and Blackrock overseeing assets worth trillions (as of 2022).

Before exploring the reasons behind this trend and its implications, let’s clarify the two primary styles of investment:

• Active Investing:
  • This strategy involves investment managers or individual investors evaluating securities, determining their value, and selecting which ones to add to a portfolio.
  • Fees are charged for the manager’s expertise and active management services.
• Index Investing:
  • This approach aims to replicate the composition of a specific index, such as the ASX200 or S&P500.
  • The portfolio’s holdings are designed to reflect the securities and their proportions within the targeted index.
  • Adjustments to the portfolio are made at predetermined times or in response to specific events like company mergers.

So, what has propelled index investing to the forefront?

1. Cost Efficiency:
   • Generally, index funds incur significantly lower fees than their actively managed counterparts.
2. The Challenge of Outperforming the Market:
   • Active investments often find it difficult to consistently beat benchmark indexes over extended periods.
   • According to the S&P Index Versus Active (SPIVA) scorecard, a substantial number of active managers fall short of the index’s performance, even after accounting for fees. For example, by the end of 2022, 58% of Australian General Equity funds performed worse than the index. This trend of underperformance extends over 5-, 10-, and 15-year periods, with rates of 81%, 78%, and 83% respectively. This pattern is similarly seen in international equity markets.

While opting for index funds may appear to be the sensible choice, it’s crucial to understand their foundation. Returns are derived from income (such as dividends) and the variation in capital value over time. However, for capital value changes to occur, there must be active trading of securities. If all investors were to solely invest in index funds, the market dynamics would fundamentally change.

Index investing does not discriminate between shares, providing investors with exposure to both ‘good’ and ‘bad’ companies without exclusions for environmental, social, or governance (ESG) criteria, which may be important to some.

In the debate between active and index investing, there’s no definitive answer. Many investors adopt a hybrid approach, using index funds or ETFs for broad market exposure and active investments for targeted areas such as smaller companies, real estate, or infrastructure.

Regardless of your investment strategy—be it active, indexed, or a combination—the essential principles of diversification and long-term market engagement remain pivotal in achieving wealth growth over time.