The Simple Reason Why Index Funds Beat Actively Managed Mutual Funds

There has been a lot of research that explains why index funds outperform actively managed mutual fund. I thought I’d share a distilled version:

An index fund has low turnover because it knows what stocks it will invest in; whatever stocks are in that index. Furthermore, because it knows the stocks it is going to invest in, it doesn’t have to pay a manager big bucks to beat the stock market. That means low fund expense ratios.

On the flip side, an actively managed fund has to try to beat the stock market by constantly buying and selling stocks. This causes turnover, which spin out capital gains and dividends that you pay tax on in your taxable accounts.

Also, if you are expected to beat the market, you should earn big money too, so actively managed funds have to pay their managers high salaries that cause them to have high internal expenses.

Between high turnover, and high expenses, it makes it very difficult for actively managed mutual funds to beat an index fund. Of course, there is not guarantee that index funds will beat actively managed funds. There are some active funds that outperform indexes. But they usually don’t outperform index funds for long periods of time. And the chances of you getting in these active funds during the periods they do outperform the indexes, and out of these funds when they under perform the index, are slim.