Beginner’s Guide to Asset Allocation: Actively Managed vs. Index Mutual Funds

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Question: Which is better, actively managed mutual funds or passively managed index funds?

Answer: Yes.

Little else will heat up a discussion among mutual fund investors than the question of whether actively managed mutual funds or index mutual funds are best. This question is not strictly a matter of asset allocation, but it's such a significant question that I've included it in this Guide to Asset Allocation. Before I explain my 'Yes' answer to the question above, let's first look at the basic differences between the two types of mutual funds:

	Actively Managed	Index
Investment Style	Fund managers research companies and make investment choices based on their research	Mutual fund automatically tracks an index like the S&P 500
Cost	Because of the research involved, costs are usually higher than index funds	Costs are generally lower than actively managed funds
Turnover	Often involve significant buying and selling of securities, which may increase capital gains tax and costs	Usually lower in index funds, reducing costs and capital gains tax
Performance	Generally does not beat its relevant index	Usually matches the performance of its index, less costs

Many believe that because index funds generally outperform actively managed funds, in part due to lower costs, that there is no place in a portfolio for actively managed funds. Others find index funds just too boring. Personally, when in comes to investing, boring is exactly what I'm looking for. In my case, though, I own a mix of both actively managed funds and index funds, which explains my 'Yes' answer above. To put it in some perspective, here are the mutual funds I own:

I've listed the funds from least expensive to most expensive. You'll note that the least expensive equity funds are all index funds. You'll also see, however, that I do own actively managed funds, at least one of which charges more than 1% (NOTE: Templeton, please lower the cost of TPINX--it's a bond fund for goodness sake!). When it comes to small cap or foreign equity, bond or REIT funds, I often own actively managed funds because they are the best options available to me. One reality of 401(k) investing is that you have limited choices and have to make the best with what options you have. That said, I'm generally pleased with all of the listed mutual funds. In small cap and foreign funds, actively managed funds perform better against their respective bench marks than do large U.S. company funds. The theory is that so much is known about large U.S. companies that it's difficult for a manager to outperform the market. In the final analysis for me, the single most important factor in the active versus index debate is cost. As you'll see from the Morningstar screen shot above, my weighted average cost is .48 percent, which is just under my goal of .50 percent.

Here are several books I recommend on asset allocation in general, including investing in actively managed mutual funds or index funds:

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