There are basically two types of funds. The first type is called the “active” managed fund which has the goal of giving returns which are higher than a certain benchmark index. They try to meet this goal by doing a combination of stock picking, asset allocation and market timing.
The second type of fund is called the passive or the “index” fund. What these funds do is that they don’t attempt to beat the index, but rather, they just try to match it as close as possible to the performance of the index. The main objective of an index fund is to give returns which are similar to the asset class, minus the minimal fees.
One of the reasons why investors are so attracted to active managed funds is precisely because of how it is intended to work. After all, why should you settle for an index fund that only matches the growth of the index when there is a fund that attempts to outperform it?
However, despite the attempt of active managed funds to outperform the index, data shows that the “mediocre” index funds, have on average, consistently outperformed the active managed funds.
According to Agriculture Mortgages UK– Actively managed funds have performances that were 1% behind from their benchmarks by an average of one percentage point every year.
For example, if the benchmark such as Standard and Poor’s 500 gave a return of 10%, the active managed funds investing in similar stocks would return 9%. However, the passive index funds would have returned 9.8% to 9.9%, which is fairly similar to the index.
Despite these figures, a majority of investors still choose active management. Only 13% of assets in mutual funds constitute indexing. There are several explanations that experts have offered.
First, investors may simply be taken in by marketing, second, that investors just don’t really know the facts and active management just sounds better, and third, that the saying “you get what you pay for” holds true and that investors believe that since they pay more for active management, then it is expected that their returns should be more as well.
However, some can argue that there are indeed active managed funds that beat the indexes. This is true, but the problem is in predicting which one of the active funds will actually beat the index in the next year.