Investors often face a choice between index funds and actively managed mutual funds. Index funds attempt to replicate the return of a given market index, such as the S&P 500 or the Russell 2000. Actively managed mutual funds use professional managers to pick individual securities and to try to beat the returns of a relevant index.
There are two general types of index funds. The first, index mutual funds, feature the same characteristics of other mutual funds except that instead of a professional manager trying to beat the target index, the professional manager tries to only match the target index. The second, exchange-traded funds, or ETFs, are baskets of investment securities, such as stocks, bonds or commodities, that trade on stock exchanges as equity securities.
Active vs. Passive
The difference between index funds and actively managed funds boils down to a question of performance vs. fees. As it is significantly more expensive to operate an actively managed fund seeking to beat index returns than to operate a passively managed fund replicating index returns, the fees charged by actively managed mutual funds are typically much greater than those charged by index funds. Professional managers running actively managed mutual funds therefore seek to not only exceed index returns, but must try to do so by at least the amount of their additional fees.
The managers of actively managed mutual funds generally have significantly greater freedom in the types of securities they may acquire for their mutual funds. Index funds managers must keep the component holdings and weightings equal to those in the target mutual fund. Active managers may buy a wider range of securities in varying proportions. Many active managers may also leverage their returns by taking on debt or may hold part of their investments in cash equivalents during uncertain market periods.
Mutual funds typically charge two principal types of fees: fund operating charges and sales loads. Operating charges are fees used to cover all general expenses of the fund, such as transaction costs and the cost of professional management. Inclusive in these fees are 12b-1 charges, which relate to the fund's marketing and distribution costs. Sales loads are fees investors pay to enter or to exit a mutual fund. These fees are common to both actively managed mutual funds and index mutual funds, although they are generally much lower for the index mutual funds. Neither fee exists for ETF index funds.
While the basic taxation principles under the U.S. Internal Revenue Code apply to both actively managed mutual funds and index mutual funds, in most cases, the index mutual funds have less turnover of the underlying investments. As a result, the annual capital gains charges to investors are typically less for index mutual funds.
ETFs are generally considered more tax efficient than either type of mutual funds, as they allow investors to defer the entire amount of capital gain until the ETF is sold.