The Benefits of Index Funds Vs Actively Managed Funds

City of London at Night

While there are many choices open to those looking to invest in funds, one of the key decisions relates whether to invest in an index linked fund or an actively managed fund.  While there is no clear answer as to which represents the best investment, it is worth taking a look at the pros and cons of each before handing over your money.

The Costs and Benefits of Index Funds

Index funds are funds which seek to give an investor an exposure to a common basket of investments referred to as an index.  Such funds may seek to mimic the performance for example of the FTSE 100 or a specific sector such as mining stocks.  The key to understanding an index fund is to consider that you should see almost like for like performance between your fund and the performance of the relevant index.

The advantage of index funds on the whole relates to costs, for example L&G’s FTSE 100 index fund has an annual management fee of 0.65%, compare this to the company’s UK Alpha fund which has an annual management fee of 1.5% and that’s after paying a 5% initial investment charge.  In short, index linked funds are usually much cheaper than actively managed funds.  However, such funds will only ever (or should) reflect the average performance of the market.

The Costs and Benefits of Actively Managed Funds

Actively managed funds by contrast seek to give levels of performance which beat the market and so in essence, one would expect to see actively managed funds giving higher levels of performance.  In an actively managed fund, a fund manager and their research team will actively trade the assets of a fund in accordance with the objectives of the investment in order to gain the best returns.  Funds may have a wide range of themes from emerging market bonds to natural resources funds and beyond.

While such funds may offer higher levels of performance than index funds (although not in all cases), the associated costs can be quite high thus eating into returns.  Here management fees may be several times those of an index fund and there may also be a high initial charge for entering the fund.  In addition, research would seem to suggest that few fund managers are able to consistently outperform the market year in year out.

So if considering whether to opt for an index based investment or an actively managed fund there are many issues to consider.  Key considerations should include the annual management charge and any additional fees such as initial investment charges.  In addition, consider carefully the level of performance seen by the fund over the long term, not just the previous year’s statistics.