Index Funds vs Active Funds

Two different approaches

An index fund seeks to follow a market index. An index is a measure of a selected group of securities. The fund may hold all of those securities or a representative sample. This is passive management: following a defined index rather than trying to choose tomorrow's winners. Investor.gov.

Active management uses a manager's investment decisions to pursue the fund's objective, often trying to outperform a benchmark. Passive and active describe strategies, not promises of success. Neither label guarantees that the fund will meet its objective. Investor.gov.

Following does not mean matching perfectly

An index fund seeks to track an index; it does not guarantee identical returns. Trading costs, fees and differences between the holdings and the index can create a gap. That gap is tracking error. An index fund also remains exposed to risks in the securities it follows. Passive management does not mean risk-free investing. Investor.gov.

Index funds may have lower costs because passive management can require less trading and research. But not every index fund is cheaper than every active fund. Compare the actual fees in the fund documents instead of assuming a label answers the cost question. Higher costs reduce what the investor retains, all else equal. Investor.gov.

Two common questions

Does an index fund hold every security in its index? Not always. Some use a representative sample, so the holdings need not be a complete copy. This is one reason to read how a fund implements its strategy. Investor.gov.

Which approach always wins? Neither is guaranteed to win. This guide explains mechanics and risks, not a universal performance ranking. Check the objective, holdings, costs and risks before drawing conclusions from the words active or passive. Investor.gov.

Explore a hypothetical portfolio in the simulator and continue with how much to invest each month.

Sources

• Investor.gov — Index Funds

This article is for educational purposes only and does not constitute financial advice.