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Index funds vs. actively managed funds

When it comes to picking a mutual fund, it's easy to feel overwhelmed. You've got thousands of different choices.

But you can make quick work of organizing your options by dividing the fund universe into two basic categories: index funds and actively managed funds.

Index funds are designed to replicate the performance of a particular market index, such as the Dow Jones Industrial Average or the Standard & Poor's 500.

A quick refresher course
  • The Dow is made up of 30 leading domestic companies such as Alcoa, General Motors and Microsoft, and its overall performance is used as a bellwether of the overall economy.
  • The 500 large-cap stocks in the S&P 500 represent leading actively traded U.S. companies. Many mutual fund managers pit their performance against that of the S&P 500 index.

Index funds are pretty straightforward, since their holdings mirror that of an index. As Paul Mladjenovic, author of "Stock Investing for Dummies," sums up: "Index funds can be run by one person and a computer."

Actively managed funds are an entirely different story. With these, a mutual fund manager or team of managers buys and sells a variety of holdings in an attempt to beat their respective index. Therefore, portfolio turnover is generally higher, the funds are less tax-efficient and they require more hands-on management.

In the end, all that activity often doesn't guarantee top returns.

It's not that fund managers aren't smart enough to beat the indexes. You may have heard about such star managers as bond king Bill Gross at PIMCO or Bill Miller, whose Legg Mason Value Trust dazzled investors by outperforming the S&P 500 for 15 years. (Miller's winning streak ended in 2006).

But in general, most actively managed funds come with higher annual expenses that eat into performance and profits, making it difficult to beat index funds. Over the past 10 years, the cheapest S&P 500 index funds (such as Fidelity Spartan U.S. Equity Index, with an expense ratio of 0.09 percent, and Vanguard 500 Index, with an expense ratio of 0.18 percent) beat more than 60 percent of their large-cap blend peers, according to Morningstar.

"It's possible to find a talented active manager who's proven his ability to beat index fund performances over the long haul, but it takes a lot of time and effort," says Sonya Morris, a senior mutual fund analyst at Morningstar.

As an example, the expense ratio for large-blend index funds currently averages 0.59 percent, but the annual expense ratio for an actively managed large-blend fund typically runs 1.22 percent, according to Morningstar.

That may not sound significant, but don't be fooled. A seemingly "small" difference in expenses can be worth a small fortune over time.

The difference fees make
  • Scenario: Imagine two investors with $10,000 each and deep convictions about how to invest their money. One puts his money in an index fund that returns 10 percent minus 0.20 percent in expenses. The other invests in an actively managed fund that also returns 10 percent annually, but its performance is dragged down by an expense ratio of 1.22 percent. Both leave money in their respective funds for 35 years.
  • The index fund is worth $263,683 after 35 years.
  • The actively managed fund is worth $190,203.
  • The difference is $73,480.

Taxes are another consideration. Remember, Uncle Sam wants his piece of the action when you sell winning investments. Because actively managed funds reshuffle their stock holdings far more frequently than index funds, they trigger more taxes than index funds, which have a buy and hold approach.

The bottom line: With their low costs and generally higher returns, index funds are the best bet for most investors. But not always.

"In international markets and places where there's not a lot of people following certain sectors, we'll use a managed fund," says Brett Horowitz, a financial planner at Evensky & Katz in Coral Gables, Fla. "If you go to a country like Dubai, how many people are following the stocks? An active fund manager may have a breadth of research to trade smarter."

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