The clock is ticking in one of the longest-standing rivalries of the last 40 years.  At one end of the field is a team renowned for its steady execution of its game plan. The roster rarely changes, and unbelievably there is no coach.  More often than not, the team has outperformed its opponent by aiming to be just “average,” rather than superlative. This team is boring to watch, but great to bet on.

At the other end of the turf is a team of aspiring stars, coached by a professional who believes that winning requires a unique strategy and analysis of tons of information.  Expect a lot of motion and play change from this team.  It competes to win, whereas its opponent plays to not lose.

The contest?  It’s the annual performance play-off between index funds and actively-managed funds.  One more quarter to go to determine this year’s winner. There may be an upset this year, after a long string of index fund wins. As a result of market volatility and the ability of managed funds to mount an active defense, they are predicted to come out ahead.

Black versus White, or Many Shades of Gray?

Many fund fans – a.k.a. investors – see “index” versus “managed” funds as one of stark contrasts.  Index funds are the plain vanilla to the Baskin & Robbins’ array of styles and approaches found in managed funds.  Index funds seek broad coverage of a given market whereas managed funds can take a narrow, specialized approach, focusing, for example, on specific industries, company size, or the cash-management policies of the investable entities.  Finally, index funds are seen as inherently tax efficient given their lower volume of trading compared with the tax costs associated with the high portfolio turnover typical of actively managed funds.

But the biggest polarity – at least to the minds of index fund champions – is defined by the level of fees.  Because computers, not humans, are the true “managers” of index funds, index fund fees are generally far lower than those for managed funds.  There is no premium to pay for judgment or discernment in an index fund: its mandate is to buy and sell securities to replicate the actual transactions of the market being indexed.  This lower cost has further been cited as the major factor in the outperformance of indexed over managed funds over the last decade.

But before you grab a hot dog and head automatically to one side of the investment arena or the other, you may wish to study the field again.  Over the past decade, players on both teams have been marching toward a middle ground, where it can be difficult to know for sure which side of the field they belong.

For example, relatively new to the arena are “Smart Beta” funds or ETFs, where an underlying index is “dressed up” by management in the effort to get better-than-plain-vanilla index performance. This often involves taking a traditional index where holdings are weighted in by their market capitalization (i.e., large firms are held in greater amounts relative to smaller firms) and changing the weighting strategy.  This might involve weighting by price-to-earnings ratios, or price volatility. While a Smart Beta fund will not be perfectly correlated with its associated market index, ideally it will outperform it, and not be a Dumb Beta fund in disguise.

Another instance of index and actively managed funds meeting in the middle are the so-called Low Cost Active funds, a genre recently offered by Vanguard, long acknowledged to be the industry champion and defender of index funds. Based on 2013 research, Vanguard believes it is possible to select above average active fund managers without sacrificing the benefit of low fees. This selection is based on empirically-observed indicators of high performance. These include symmetrical alignment of managers’ compensation with investment return, as well as requisite fund scale to allow lower fees.  

Finally, there are now many managed funds that use tax-management strategies, such as last-in first-out selling of appreciated securities, to achieve some of the tax efficiencies generally associated with index funds.

In the perennial performance battle, it is perhaps inevitable that the two sides– indexed versus managed – would begin to look the same, further complicating the investor’s choice. Investors must nevertheless consider their own goals and circumstances, and not just attributes of the different types of funds. What works for one investor may not work for another.

  • The Young Investor:  Mutual funds are a great investment choice for kids and teens, as a way to get diversification at very small levels of investment.  But the choice needs to engage their imagination and interest as well.  This may be difficult to do with an index fund, which relies on a fairly sophisticated and dry explanation of capital markets.  Managed funds often have a “story” behind their holdings that can be much more entertaining. Kids can relate to a fund that holds a lot of Disney or Apple, but an S&P 500 index is hard to get excited about. 
  • First-Time Participant in a 401(k):With a new job comes decision overload: how many W-9 allowances, how much deductible to choose for the health plan, how to invest in the employer’s retirement plan.  A broad index fund is a good choice for the new participant.  It provides instant diversification and usually lower volatility than a managed account, and does not require much thought or monitoring. 
  • The High Tax Bracket Investor:  This investor is likely to have a number of different investment accounts – brokerage, tax-deferred retirement accounts, Health Savings Accounts and ROTHs.  In this case, she might use index funds for her taxable accounts, and put her favorite high-performing managed account into the tax-deferred or tax free accounts, to minimize her annual taxable income from her investments. 
  • The Socially Responsible Investor:  Some investors feel strongly about the individual positions held in funds. While socially responsible index funds do exist, they may weight their holdings in a manner that does not reflect the most cherished causes of the investor, such as community involvement, women’s rights, or environmental preservation. Here is where the characteristic diversity of managed funds can be a plus too, allowing the investor to find a fund that is tilted toward his particular interests. 
  • The Plug and Play Investor:  Index funds adjust with changes in the markets, not with changes in the investor.  But some investors want their fund to adjust over time, to reflect their proximity to a given life goal, such as retirement or starting college.  Others want a fund to take care of asset allocation, rebalancing, and risk management for them, as opposed to having to do it themselves by choosing a variety of funds and adjusting their holdings in each.  This is where the managed options of target date or asset allocation funds can make sense. 
  • The Hedger:  Some investors have very particular risks they wish to manage: such as the rising cost of medical care in their retirement years, or the scarcity of water where they live.  Here’s where an index can come in handy as a relatively simple way to hedge these risks. It’s important to understand, however, that indexes narrowly targeted to a specific industry or commodity can be inherently high-risk and volatile, and should be selected with care. 

At the end of the day, at the end of the year, it matters far less whether index funds beat fund managers, or humans face down the computer.  What matters is the financial success of the investor.  That success depends on a lot more than just reading fund prospectuses. The advice of a CFP® professional, who puts your interests first, is important, too.