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Sorting through thousands of mutual funds to find the ones most appropriate for you can be a daunting challenge. One way to start is by narrowing down the categories of funds that might fit into your investment plan.

The type of fund you choose can have an impact on how your portfolio performs. Stock funds historically have delivered higher investment returns than bond funds, for example, but their year-to-year returns have been more volatile. Accordingly, stock funds may have more appeal for someone with a long-term investment horizon that gives them time to ride out the economic and market cycles, while bond funds may have more appeal for people with shorter investment horizons and less tolerance for volatility.

Beyond the types of investments they hold, mutual funds also can be categorized based on their fund manager’s investment style – active management or passive management.

At first blush, it might seem that all mutual funds would qualify as actively managed funds. After all, each fund has a manager or team of managers, and all those managers routinely make decisions about which securities their funds should buy and sell, and when. But in the investment management world, the terms active and passive refer to why fund managers make those buy or sell decisions.

In actively managed funds, managers decide to buy or sell securities based on their expectations for how those securities will perform. Typically, an actively managed fund will seek to outperform a designated index or benchmark that aligns with its investment mandate—the S&P 500 Index, for example, for a large-cap stock fund. (The S&P 500 Index is a market-cap-weighted index that represents the average performance of a group of 500 large-capitalization stocks.) 

By contrast, passively managed funds – also known as “index funds” – do not attempt to outperform a designated index. Rather, they simply seek to mirror the performance of an index by holding the same or similar securities in the same proportions. The managers only buy or sell securities as necessary to correspond with the index.

There’s no right or wrong answer to whether you should invest in active or passive mutual funds. Both types are popular. Almost 45% of all equity (stock) assets in U.S. mutual funds and exchange-traded products are passively managed, according to research firm Morningstar Inc., leaving a bit over 55% in actively managed funds.i

Beyond investment style, one other area where active and passive funds differ is in their costs. Expense ratios of actively managed funds, which require ongoing analysis and portfolio management, are typically higher than passively managed funds.

That said, fees for both types of funds have been trending down in recent years. The average expense ratio of actively managed equity mutual funds fell to 0.76% of assets under management in 2018 from 1.04% in 1997, according to a 2019 report from the Investment Company Institute. Index equity mutual fund expense ratios fell to 0.8% from 0.27% over the same time period.ii

According to the report, “interest in lower-cost equity mutual funds, both actively managed and indexed, has fueled this trend, as has asset growth and resulting economies of scale.”

 

“Passive Investing Rises Still Higher, Institutional Investor, May 21, 2018

ii “Expense Ratios of Actively Managed and Index Funds Have Declined for More Than Two Decades,” Investment Company Institute, March 21, 2019

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