What an index fund tries to do
An index fund holds the companies in a chosen market index, in roughly the same proportions. A market index is a list of companies that stands in for part of the market, such as large firms in a home country. The fund does not try to pick winners. It aims to match the index return, minus the yearly costs of running the fund.
Because the fund follows the index, it does not need a team to choose holdings. It holds the same companies whether markets rise or fall. When the index changes its list of companies, the fund adjusts its holdings to match.
What an actively managed fund tries to do
An actively managed fund is run by a manager or a team who choose which investments to hold. Some managers focus on value, others on growth, and some combine many approaches. They research companies and markets, then buy and sell with the aim of outperforming a chosen benchmark, meaning the index or yardstick the fund is measured against. Their decisions can be wrong, so results vary widely from year to year.
Who decides what the fund holds
The key difference is how much work goes into deciding what the fund holds. Index funds rely on the index for that decision, so their running costs tend to stay low. Actively managed funds pay for research, staff and frequent trading, and those costs reduce the return the investor keeps. Extra costs must be earned back before an active fund can help the investor at all.
This matters most over long periods, when small yearly differences add up. A gap that looks minor in a single year can change the final result noticeably.
When an index fund tends to win
An index fund tends to suit an investor who plans to hold for the long term. It suits someone who wants broad exposure, meaning holdings spread across many companies, without much research. Its results stay close to the index, so its performance is easier to predict. It also suits an investor who does not want to rely on a manager's judgement.
Many actively managed funds have trailed their benchmark after costs over long periods, although this varies by market and by fund. This pattern is a reason many investors start with an index fund.
When an actively managed fund tends to win
An actively managed fund may suit an investor who wants a narrow focus, such as a specific sector or theme that an index covers loosely. It can also make sense in markets where information is harder to find, giving a skilled manager more room to add value. Results still depend heavily on the manager. A good track record does not promise future returns.
How to judge a fund against its benchmark
Start by checking which benchmark the fund names and whether its holdings match that benchmark. Then compare the fund's return with the benchmark over several years, not a few months. Use the same time period and the same currency for both. Remember to compare returns after running costs, because that is the figure the investor keeps.
A fund that closely copies its index is effectively an index fund, so judge it on that basis. Look for the provider's factsheet, a short summary document that sets out the benchmark and the running costs. Check the provider's own material for current figures, because they change over time. If you still need to pick where to hold the fund, read how to choose an investment platform.
Which to pick
Think about how much time you want to spend choosing, how comfortable you are with results that differ from the market, and how long you plan to hold. Your situation matters more than any headline result.
- A hands-off investor who wants broad exposure and lower running costs will usually find an index fund the simpler fit. It can be held inside a stocks and shares ISA, which is a UK account for investments.
- An investor who enjoys researching managers, and who accepts that results can lag the benchmark, may look at an actively managed fund for a specific goal.
- An investor who is unsure can hold a mix of both, sized to match their goal and the amount of risk they can accept.
Whichever you choose, confirm the current running costs with the provider before you buy. Then check the investor protection that applies where you live, since this varies by country and by provider.