Perspectives : Investment | September 19, 2024

Active and index fund investing, two sides of the same coin

Implementing an investment strategy is often presented as a choice based on whether a fund is labeled “active” or “index.” Those labels are important, as they convey pertinent information about funds. However, I believe it’s more important that investors consider the characteristics behind those labels. Doing so can strengthen investors’ conviction about why they might include active and index funds in their investment plan and can increase their chances of success.

Fund characteristics: A reasonable starting point

Deciding whether to gain exposure to a market segment with active funds and/or index funds can be a detailed and complex process, but the process has to start somewhere. For investors who might not know where that is, it’s reasonable to first consider certain characteristics grounded in Vanguard’s Principles for Investing Success—goals, balance, costs, and discipline. The figure that follows highlights how these characteristics relate to successful active and index fund investing.
A foundational framework for considering index and active fund investing
Vanguard's Principles for Investing Success

Look beyond the labels

Vanguard’s latest research papers, Considerations for Active Fund Investing and Considerations for Index Fund Investing, provide further details. The papers are complementary works and are intended to be the foundation for more advanced concepts such as portfolio construction.

Both research papers outline primary factors empirically proven to improve investors’ chances of achieving investment success for each strategy. In this way, indexing and active strategies are two sides of the same coin.

Considerations for Index Fund Investing confirms the finding that there is no escaping the zero-sum game in investing and that most funds will underperform their benchmarks net of cost. For investors who want to maximize relative performance predictability or are seeking a fund that will help them develop discipline and stay the course, an index fund may be most appropriate.

Considerations for Active Fund Investing focuses on what it takes to improve one’s chances of selecting active funds on the winning side of the zero-sum game:

  • Investor tolerance for active risk.
  • Conviction in a manager’s capabilities and strategy.
  • A focus on curtailing cost.
  • Recognition that the road to outperformance is bumpy.1

Put simply, while index fund investing benefits all investors, active management can also be a good choice for many. And of course, both investment strategies can, and often do, successfully coexist in investors’ portfolios.

 1Active risk is defined as the level of dispersion around benchmark returns over time.

Make an informed choice

Millions of investors have achieved success with both actively managed and index funds. Vanguard wouldn’t offer both strategies if that wasn’t the case.

Ultimately, what makes an investment strategy right for an investor is not a fund’s label, but rather whether its underlying characteristics are aligned with an investor’s unique investment goals, risk tolerance, and time horizon.

Notes:

  • CFA® is a registered trademark owned by CFA Institute.
  • All investing is subject to risk including the possible loss of the money you invest.
  • Diversification does not ensure a profit or protect against a loss.
  • Past performance is no guarantee of future results.
James J. Rowley, Jr.
Vanguard Global Head of
Investment Implementation Research