Index Funds vs Active Funds

We all know investments are a mechanism to ideally earn income, and increase wealth over time. If investments are not made in individual companies directly, they can be invested via managed funds which hold a parcel of investments. How these funds operate, and where and how they invest, can be vastly different but one of the key differentiators is if they are an index fund or active fund.

What is an Index Fund?

An index fund is a type of managed fund or exchange-traded fund, where the fund will follow a set of rules, so it tracks an underlying market that it is tied to. An index fund will hold a portfolio of shares or bonds, which in effect will mimic the performance of a particular financial market index. As this is a set formula this type of fund is considered a passive investment strategy, where returns are closely aligned to the returns of the corresponding index. Generally, when people speak of index funds, they are talking of those that are tied closely to the wider market index for instance the ASX100 or S&P 500.

Beyond funds tied to a complete index, there are also index funds that may offer exposure to only particular companies within an index. For example, there are index traded funds that only hold shares in large, medium or smaller companies, known as large-cap, medium-cap, or small-cap funds. Index funds may also focus on geography (such as Asia or Europe), a Business sector (such as Technology or Energy), or other differentiators.

One of the benefits of an index fund is the fees involved with buying, selling or holding are generally a lot lower than those of an active fund.

What is an Active Fund?

Active investing is a more hands-on investment approach taken by a fund, where the fund is generally managed in a proactive way to take advantage of market moves or opportunities. An active fund may rely on a sole manager or team of managers that attempt to outperform the market or outperform what an index fund would achieve. A fund manager makes decisions where and when to invest funds, usually within a broad strategy or investment approach, or sector that differentiates the fund from others.

There of course is no guarantee an active fund will outperform the market, and to be ahead an active fund would need to outperform the market enough to account for additional fees and expenses in holding an active fund. Like index funds, active funds come in all shapes and sizes, however as active funds strive to achieve greater returns, they also bear greater risks and higher fees.

Which to choose?

That is the big question! The opportunity to outperform the market is hard to resist. And some actively managed funds, who target the right opportunities can see many multiples of market returns. Others however underperform compared to the market and after higher fees are taken into consideration, returns can be rather disappointing. If you care about what you invest in, for instance, those with a quality, growth, dividend, ethical or environmental filter, then active funds may better choice for you.

Ultimately it’s a personal decision, and one you should make in conjunction with your financial advisor. It is also not a one or the other scenario. You may choose to have your funds in a range of funds, with a percentage in index funds, and a percentage in active funds. If you are a firm believer in the growth of a particular industry or investing style you may choose to allocate funds to an active fund that follows that ethos. If you are more conservative and would like to not take bets in any particular focus area then index funds might be a better option.

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Rodney Rossi

As the Senior Financial Advisor heading up the q4 financial wealth management division I take great pride in the work we do here to provide our clients with comprehensive and integrated tax, accounting and financial planning services. If you are interested in having an informal chat about how we may be able to help you please contact us at admin@q4financial.com.au 

This document contains general advice. It does not take account of your individual objectives, financial situation or needs. You should consider talking to a financial adviser before making a financial decision. Q4 Wealth Management Pty Ltd, ABN 18 634 775 830, is an Authorised Representative of Hunter Green Pty Ltd, ABN 12 087 491 629 AFSL No. 225 962.