The Great Debate: Actively Managed Funds vs. Index Funds

The debate between actively managed funds and index funds has been ongoing for a while now. But, in recent years, the scorecard has consistently tilted in favor of the broad stock market index, specifically the S&P 500.

Outperformance: A Rare Occurrence

According to Morningstar Direct, only 18.2% of actively managed funds whose primary prospectus benchmark is the S&P 500 have managed to outperform the index in the first half of this year. This is on track to be worse than last year, when only 19.8% of actively managed funds beat the S&P 500.

Why Actively Managed Funds Struggle

Of course, some years are better for fund managers than others. In 2022, when the Federal Reserve launched its most aggressive rate-hiking cycle in decades and sent the S&P 500 tumbling, 63.3% of active funds outperformed. In 2014, only 14.2% did. Over the past 10 years, the average share of active funds that beat the S&P 500 was 27%, setting up 2024 to be an especially weak year.

Passive Funds: The Default Choice

Data from Morningstar Direct also shows that 13.4% of passively managed funds are outperforming so far this year. And over the past decade, passive funds consistently trailed active funds in the share that beat the S&P 500. But, that’s not surprising given that many passive funds are only looking to keep pace with the index and maintain lower expenses rather than charge higher fees and hope to get bigger returns.

Index Investing: A Low-Risk Strategy

To be sure, the vast majority of the S&P 500’s recent gains have come from just a handful of tech giants. That leaves index investors vulnerable to a selloff in one stock like Nvidia. Still, even as Nvidia has come well off its highs over the past few weeks, the index has continued to hit fresh records as other stocks climbed.

Exchange-Traded Funds (ETFs): The Weakest Link

Separate data showed that the S&P 500 beat three out of every four exchange-traded funds (ETFs) in the past year, the worst showing for ETFs since at least 2010.

Diversified Portfolios: A Recipe for Underperformance

In addition, funds that are diversified across asset classes and geographies also fared worse than the S&P 500. Such portfolios have lagged the index in 13 of the last 15 years, according to data from Cambria Funds cited by Bloomberg. Other data showed that out of 370 asset-allocation funds tracked by Morningstar, just one has beaten the index since 2009.

A Simple Strategy

"In a low-volatility, high-return environment like 2024, investors should stick to the basics — buying uncomplicated index funds, and active mutual funds with a proven track record of delivering alpha," Evercore strategist Julian Emanuel told Bloomberg last month. "No need to complicate strategy. In simplicity there is beauty."

Conclusion

The debate between actively managed funds and index funds continues to favor the latter. While actively managed funds may struggle to outperform the S&P 500, index funds offer a low-risk strategy that can help investors achieve their financial goals.

FAQs

Q: What is the S&P 500?
A: The S&P 500 is a stock market index that represents the market value of 500 large, publicly traded companies in the US.

Q: What is an actively managed fund?
A: An actively managed fund is a type of investment fund that is managed by a professional investment manager who actively buys and sells securities in an attempt to beat the market.

Q: What is an index fund?
A: An index fund is a type of investment fund that tracks a specific market index, such as the S&P 500, and holds a representative sample of the securities in the index.

Q: Why do actively managed funds struggle to outperform the S&P 500?
A: Actively managed funds struggle to outperform the S&P 500 because they often incur higher fees and trading costs, which can erode their returns. Additionally, they may make mistakes in their investment decisions, which can lead to underperformance.

Q: Are passive funds the default choice?
A: Yes, passive funds are often the default choice for investors because they offer a low-cost and low-risk strategy that can help investors achieve their financial goals.

Q: What is the average share of active funds that beat the S&P 500 over the past 10 years?
A: The average share of active funds that beat the S&P 500 over the past 10 years is 27%.

Author: fortune.com

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