How Does an Index Fund Differ From an Actively Managed Fund?

by Martha A. Brozyna

Overview

Index funds seek to replicate the return of a selected stock market index.

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Two types of management are available for mutual funds or exchange-traded funds: the index fund and the actively managed fund. Index funds seek to replicate the return of a selected market index. Actively managed funds have managers making investment decisions based on their insight.
Index Funds

Index fund costs are low because they require no high-earning portfolio managers. These funds hold a basket of securities that closely corresponds to those in the underlying index.

Actively Managed Funds

Returns are normally judged against a benchmark index, and the intention is to beat the return on that index. Investors may benefit from a manager's ability to choose winning stocks or bonds.
Disadvantages of Indexing

The makeup of the fund is largely pre-set and changes little, so turnover of securities is low. The main disadvantage is that an index fund by definition cannot outperform its benchmark index; it will match it.
Disadvantages of Active Management

There is always the risk that the fund manager will not perform satisfactorily, failing to reach the benchmark return. Moreover, there are higher costs associated with active management.
Enhanced Indexing

Enhanced indexing is a hybrid method that seeks to profit from the advantages and avoid the disadvantages of both styles. These funds are overseen by managers who make limited buy/sell judgments that tweak the portfolio in an effort to earn better profits.