Active vs. passive investing

You can trace the roots of index investing to the 1970s, when some economists began advocating the efficient market hypothesis. This theory holds that a stock’s market price accurately reflects everything that investors know about the security and that future prices can’t be predicted based on past performance. Due to what they describe as the random walk of prices, proponents of the efficient market theory believe that no investor has an advantage in predicting future prices, making it impossible to consistently outperform the market. The efficient market theory set the stage for the creation of the first index investments, which are designed to match, rather than beat, market performance.

Actively managed vs. passively managed investments

In actively managed funds, fund managers try to capitalize on market conditions, exercising trades to try to maximize profits or minimize losses. Fund investors pay for the manager’s expertise — and the research behind it — through management costs that are part of a fund’s expense ratio. The active trading that some fund managers do can also generate high turnover in a fund portfolio leading to short-term capital gains and high transaction costs.

Index funds, on the other hand, are passively managed. Securities in the fund change only when the underlying index adds or drops a security from its listings. Because index funds require little active management, they are typically cost-efficient investments and usually have lower expense ratios than actively managed funds. Plus, because index funds buy and sell investments infrequently, they tend to be tax-efficient.

Whereas the average expense ratio for actively managed mutual funds is around 1.5%, many index funds charge around 0.2% or less. This price difference means that actively managed funds must outperform their passive, index-based relatives by a considerable margin just to deliver the same results.

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