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

Beginner's Guide to Actively Managed vs. Index Mutual FundsQuestion: 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.

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 (this was as of July 2007; today my investments have changed some, but not my basic strategy):


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 (Update: That has changed since writing this article. I now have index funds for most of these asset classes).

One reality of 401(k) investing is that you have limited choices and have to make the best with what options you have. (Here’s a podcast on how to compare funds in your 401k.) 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. (Update: My goal today (2014) is to keep costs below .25 percent; my investment costs currently stand at .22 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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Topics: Asset Allocation

One Response to “Beginner’s Guide to Asset Allocation: Actively Managed vs. Index Mutual Funds”

  1. JC Webber III

    I can’t remember if I’ve shared this with you already or not or if that was some other blog, but here’s my current expense ratio:

    Vanguard Taxable % $
    VFIAX 511946.71 0.040000 204.78
    VEXAX 256270.61 0.080000 205.02
    VMMXX 4372.12 0.160000 7.00
    VTIAX 118104.06 0.110000 129.91
    Total 890693.50

    Vanguard IRA
    VICSX 133003.45 0.070000 93.10
    VFIDX 97017.27 0.100000 97.02
    VGSLX 87528.98 0.120000 105.03
    VSIAX 87324.00 0.070000 61.13
    VTABX 39768.86 0.120000 47.72
    VBR 3705.60 0.070000 2.59
    Total 448348.16

    Vanguard ROTH
    VSIAX 34864.74 0.070000 24.41
    Total 34864.74
    Expense Ratio 0.071163 977.71

    Vanguard Taxable 890693.50
    Vanguard IRA 448348.16
    Vanguard ROTH 34864.74

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