Deciding how to invest can be a daunting task with all the alternatives out there. Luckily, investing has gotten easier with the widespread availability of index funds and exchange-traded funds.

Index funds take less research and tend to be easier to implement and manage than actively managed funds. Plus they outperform the average actively managed fund so you are more likely to earn higher returns using index funds.

Quick Definitions

An index fund is a type of mutual fund designed to replicate the returns of a specified market such as the S&P 500 or Dow Jones. These funds are also called passively managed funds because the manager is not trying to beat the market they’re only trying to track the index.

Exchange-traded funds also track indexes much like an index fund except they can be bought and sold during the day like a stock.

An actively managed fund aims to beat a specified market, like the S&P 500, by actively researching and trading stocks.

Index Funds Perform better than Actively Managed Funds

Index funds have been shown in numerous studies to perform better than actively managed funds. A recent paper by Vanguard’s research team looked at fund returns through 2013 and found actively managed funds underperformed their stated benchmark across most categories and time periods.

Index funds will save you research time and most likely will also earn you better returns.

Index Funds Stay the Course

There’s little evidence that the past performance of actively managed funds predict future performance. So even if you are able to pick a winning fund one year, it’s unlikely that it will continue to outperform the market over time.

One of the most difficult aspects about investing is deciding when to sell a fund that is underperforming. Investing in index funds makes sure you are always tracking market returns and not underperforming.

Index Funds Cost Less to Operate Than Actively Managed Funds

Take for instance an actively managed fund with a 1% annual expense ratio compared to an S&P index fund with an expense ratio of 0.17%.  A $100,000 investment in the actively managed funds fund will cost approximately $12,300 in expenses over ten years compared to just $2,200 over the same period for the passively managed index fund.

In order for an actively managed fund to be profitable for its investors, it has to beat the benchmark plus the cost of managing the fund.  The higher the cost, the harder this is to do.

Index Funds are Tax Efficient

Actively managed funds have a higher turnover rate than index funds since they are buying and selling stocks more often. This leads to higher capital gain taxes for investors. Selling an underperforming fund that was once a good performer can also lead to heavy capital gains in a taxable account.

Index funds save in taxes by having lower turnover. There will also be less reason to sell due to underperformance.

Index Funds Are Easier to Rebalance

Actively managed funds often suffer from style drift. This is when the fund manager begins investing in stocks that are outside the fund’s investment objective.

This makes rebalancing your portfolio tricky because you don’t know exactly how you are invested. With index funds, you know exactly how you are invested so rebalancing is an easier process. Rebalancing will have you selling high and buying low and will help you earn higher returns over the long-term.

Branching Out With Index Funds

There are an increasing number of market sectors that you can invest in with index funds, and even more are available using exchange traded funds. You can choose from equities from all over the world and also from different sectors of the economy.

Fixed income index and exchange traded funds have also been growing.  You can now invest in sectors such as international bonds, emerging market bonds, municipal debt, inflation-adjusted bonds, corporate bonds, and floating rate bonds.

Index funds work for someone just starting out in investing or someone that has been building a portfolio for years.  You can keep your portfolio simple by using an US total equity index funds and a total bond index fund. Or you can design a detailed portfolio using the different sectors now available.

Either way, index funds and exchange-traded funds offer a cost efficient and time saving strategy that also offers higher returns.