Managed Funds Versus Index Funds

JAMES HURWOOD
6 August 2021
Managed or index funds, it’s an often-held debate between investors. And to a certain extent, the decision as to which one is “best” will come down to personal preference. That said, it’s always worth looking at some statistics.

Comparing index funds and managed funds

If you’re not looking to invest directly in shares, you may be tossing up between putting your money in an index fund or a managed fund. There are three key differences between the two which are important to consider before choosing which option is right for you. This involves looking at the set up of their management style, the investment objective of each and the associated cost. The biggest difference between index funds and managed funds is that index funds invest in a set is of securities (i.e. the ASX 200 index) whereas the funds in a managed fund are actively chosen by an investment manager. Because of this, it means that managed funds often have higher fees than index funds, index funds look for market average returns whereas active funds try to outperform the benchmarked average and the performance of index funds is generally more predictable than it is for managed funds.

Recently, the S&P Dow Jones released their SPIVA Australian Scorecard for the year ending June 30, 2020. This regular scorecard reports on the performance of Australian actively managed funds versus the relevant benchmark index for each of those funds, and it may provide some insights to finally put the debate to bed.

The report notes that while the S&P/ASX 200 saw an increase of 13.2% in the year ending June 30, 2020, Australian large-cap equity funds only managed to average a 10.2% increase. Here’s a quote directly from that report:

“There is nothing novel about the index versus active debate. It has been a contentious subject for decades, and there are few strong believers on both sides, with the vast majority of market participants falling somewhere in between.”

The difference in cost and goals between managed funds and index funds

While index funds aim to follow and index, managed funds try to beat this benchmark. This involves an investment manager selecting which stocks, bonds and other securities will perform, which is an active expensive. Managing a fund requires regular investment decisions.

In an index fund, there isn’t active oversight in deciding which stocks to buy and sell. The holdings automatically track an index, matching the same stock allocation. The performance of the index fund is based on the price movements of the individual stocks in the index and not because of any trades being made by one person or team. This makes index funds passive.

Managed funds on the other hand are determined by the fund management team who can buy and sell investments for the fund, choosing how many to buy and what type within reason. Interestingly, over time it has been found that it is very hard to beat the passive market returns from index funds every year.

Performance of Managed funds vs index funds

Here are some findings from the SPIVA ScoreCard concerning the Australian market:

  • Out of all Australian equity general funds:
    • 83.8% underperformed against the S&P/ASX 200 on a 5-year basis
    • 74.6% underperformed against the S&P/ASX 200 on a 3-year basis
    • 53.6% underperformed against the S&P/ASX 200 on a 1-year basis
  • Out of all Australian Equity Mid- and Small-Cap funds:
    • 78.6% underperformed against the S&P/ASX Mid-Small Index on a 5-year basis
    • 60.2% underperformed against the S&P/ASX Mid-Small Index on a 3-year basis
    • 53% underperformed against the S&P/ASX Mid-Small Index on a 1-year basis
  • Out of all Australian Bond funds:
    • 71.4% underperformed against the S&P/ASX Australian Fixed Interest 0+ Index on a 5-year basis
    • 77% underperformed against the S&P/ASX Australian Fixed Interest 0+ Index on a 3-year basis
    • 63.6% underperformed against the S&P/ASX Australian Fixed Interest 0+ Index on a 1-year basis
  • Out of all Australian Equity A-REIT (real estate investment trusts) funds:
    • 60.3% underperformed against the S&P/ASX 200 A-REIT Index on a 5-year basis
    • 58.8% underperformed against the S&P/ASX 200 A-REIT Index on a 3-year basis
    • 54.5% underperformed against the S&P/ASX 200 A-REIT Index on a 1-year basis

But, is there more to the story?

The obvious conclusion that can be drawn from SPIVA’s findings is that passive funds are likely to out-perform their managed counterparts, possibly making them a safer and more prudent addition to some investor’s portfolios.

However, it could be unwise to discount actively managed funds based solely on this data. Active funds are handpicked with risk management in mind. Therefore, during times of market volatility they could be your saving grace. It is also worth noting that markets are cyclical and while at the moment passive investments are coming out on top, at some point this could shift as it has done in the past. After all, it’s important to keep in mind that past performance isn’t a guarantee of future returns.

What to consider before investing in active managed funds

If you’re keen to put your money in an active managed fund, remember to consider fees because they can eat into your returns. Actively managed funds tend to charge higher fees for the privilege of hand-selected investments, along with more staff, more analysis and more active trading.

There will always be fund managers who have superior investment-picking skills. So, if you can take away one lesson from this data, it should be to carefully select your fund manager as they are not all created equally.


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