There are two basic types of mutual funds:
Actively Managed Mutual Fund
In this type of mutual fund the fund manager attempts to pick investments which he or she feels will outperform the overall market. Typically this type of fund does a lot of buying and selling of individual investments, turning over its portfolio about three times per year. The average charge for a actively managed stock mutual fund is about 1.35%. This means that every year the investors in the fund are charged about $13.50 per $1,000 invested.
Passive (Index) Mutual Fund
In this type of mutual fund the manager follows a published index (e.g. the S&P 500). They buy and hold the stocks in the index only selling or buying new stock when the index changes. The turnover in an index fund is usually very low, less than 10%. A low cost index fund has a management fee of roughly 0.15% or $1.50 per $1000 invested.
Why are Passive Funds a Better Choice?
Lower Management Fees
In order to just equal the index fund performance the active fund must out perform it by 1.2% per year (1.35%-0.15%). That may sound easy, but the number of actively managed funds that manage to do this is quite low. On average actively managed and passive index funds perform about the same before fees are considered. Once fees are added in then the actively managed funds underperform passive index funds. The longer the time period the fewer actively managed funds outperform low cost index funds.
Because actively managed mutual funds turnover their portfolio much more frequently than passive index funds they generate much higher short-term capital gains on stocks they held less than a year. Even if the investor does not sell their shares in the mutual fund, and reinvests all capital gains, they still will have a tax bill for the capital gains their mutual fund generates. The short term capital gains are taxed as ordinary income. These taxes can significantly reduce long-term performance.
A low cost passive index fund, generates much lower capital gains. Most of the gains for an investor are only realized when she sells her shares in the fund. Those gains are much more likely to be long-term capital gains which are taxed at a lower rate.
Actively managed mutual funds only disclose their holdings a couple of times per year. This means that a fund that is considered “Large Cap” may have significant holdings in “Small Cap” companies without disclosing it. This means that the investor has a different risk/return profile that he realizes.
A passive index fund is almost always invested in line with it’s published index meaning that the investor’s risk return/profile is in alignment with what she thinks it is.
So who is pushing actively managed funds?
Often actively managed funds are pushed by brokers who earn a commission from selling them, or a told to sell them by their firms.
Most independent experts agree that investing in low-cost passive index funds is a great strategy for most investors.