Should I Invest in a Managed or Unmanaged Fund? An Analysis for High Net Worth Investors

When building an investment portfolio, high net worth individuals and families often consider including managed mutual funds alongside or instead of unmanaged index funds. But is paying higher fees for active management worth it? This post analyzes key factors to help determine if managed or unmanaged funds are the better choice.

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Performance

A major reason to choose actively managed mutual funds is the potential to outperform the market benchmarks that unmanaged index funds track. Skilled fund managers may spot opportunities to beat the market through security selection and trading².

However, most studies show index funds matching or outperforming actively managed funds over the long term. Over a 5-year period from 2018-2022, approximately 87% of large-cap U.S. actively managed funds failed to match the S&P 500 index³. Low costs and lower turnover help index funds compete.

Still, some actively managed funds do beat benchmarks occasionally. Over the past year, 48.92% of active funds outperformed the market¹⁰. For investors open to some risk in pursuit of higher returns, actively managed funds remain an option.

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Fees

Higher expenses for portfolio manager salaries, research, trading, and marketing make most actively managed mutual funds cost more than index funds. Actively managed equity mutual funds average a 0.68% expense ratio versus just 0.06% for index mutual funds¹⁰.

Higher investment costs directly reduce net returns. Over decades, those expenses compound and can significantly reduce portfolio growth³. However, some managed funds now approach the lower costs of index funds, improving their competitiveness¹⁹.

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Risk

Actively managed mutual funds take on additional risks in pursuit of higher returns. A fund manager may make poor investment decisions or fail to protect against market declines. Index funds simply match market performance instead of trying to beat it⁶.

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Over a 10-year period, the majority of managed funds failed to match or beat benchmark returns, demonstrating those additional risks³. High net worth investors should consider their risk tolerance given the odds of underperformance.

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Tax Efficiency

The infrequent trading of index fund managers creates fewer annual capital gains distributions, making index funds more tax efficient⁴. Actively managed funds realize more gains from frequent trading, although some now use tax-loss harvesting and other strategies to improve tax efficiency¹¹.

ETFs provide another tax efficient option for high net worth investors. Their unique structure minimizes capital gains taxes for shareholders compared to both index mutual funds and actively managed funds¹⁴.

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Liquidity

The daily pricing and trading of mutual fund shares provides reliable liquidity for both index and actively managed funds. ETFs, with intraday pricing and trading, can provide even greater liquidity⁵.

High net worth investors prioritizing liquidity may prefer either actively managed mutual funds or ETFs. Both offer quicker access to cash over individually held stocks or bonds if needed.

Conclusion

While some actively managed funds outperform the market, index funds match market returns over the long run at much lower costs. Their tax efficiency provides additional savings. ETFs offer another low-cost, tax-efficient option with high liquidity.

High net worth investors might want to consider low-cost index funds or ETFs to form their portfolio core, then add actively managed funds only to target specific strategies if risk and costs are acceptable. As Warren Buffett recommends, “Consistently buy an S&P 500 low-cost index fund” ²⁰. Staying invested for decades allows the power of compounding to build wealth.