Why Passive Funds are Usually Better than Active Funds

In this post, I will be discussing the difference between passive index funds and actively managed funds and how they are slowly but surely milking the money from your pocket.

How actively managed funds work?

Actively managed funds work pretty much like this: Someone is actively following the markets and trying to time the buys and sells of the fund at the right time to beat the index. By doing so, there is always room for human error. They might have a strict set of rules on when to buy and when to sell, but still, they rarely can beat the index in the long run.

Most of the actively managed funds can’t beat the index they are trying to win. On top of that, actively managed funds charge much higher fees than index funds. For example, even if the actively managed fun manages to beat the index by 1 percent for one year, if the fees of the fund are 2 percent, guess who is going to lose. You guessed it, you. If you put your money into a fund like that.

There is even more. If the market faces a bad year, ending up lower than last year, on top of the initial loss, you will still be paying the 2% fee. Some funds even have deposit and withdrawal fees. These can be for example, 1%, meaning if you wish to deposit 100 dollars and withdraw it the next day, you would be getting back around 98 dollars just by doing so.

How much will the fees affect your returns?

The 2% fee might not seem like much at the time of buying it. However, there is a major difference between 2% fee and no fee in the long run. Even if the fund manages to get similar returns to the index, which most of the time isn’t the case, in the long term, your earnings will take the hit. See the example below between a 2% fee and no fee with an 8% annual return on investment.

Here is a little example on how much the 2% difference will affect your returns in the long run.

8% annual return2% fee withno fee
Initial investment         10 000        10 000
year 1         10 600        10 800
year 2         11 236        11 664
year 3         11 910        12 597
year 4         12 625        13 605
year 5         13 382        14 693
year 6         14 185        15 869
year 7         15 036        17 138
year 8         15 938        18 509
year 9         16 895        19 990
year 10         17 908        21 589
year 11         18 983        23 316
year 12         20 122        25 182
year 13         21 329        27 196
year 14         22 609        29 372
year 15         23 966        31 722
year 16         25 404        34 259
year 17         26 928        37 000
year 18         28 543        39 960
year 19         30 256        43 157
year 20         32 071        46 610
year 21         33 996        50 338
year 22         36 035        54 365
year 23         38 197        58 715
year 24         40 489        63 412
year 25         42 919        68 485
Difference between 2% fee and no fee during 25-year period.

As you can see, there is a big difference between these two. With a 2% fee your initial investment of 10 000 dollars would have turned to roughly 43 thousand. With no fee the amount would be over 68 thousand. You don’t have to be a mathematician to spot the difference.

The difference gets bigger the longer you invest

The difference will be even bigger after the 25 year mark. Check out the chart below.

year 26         45 494        73 964
year 27         48 223        79 881
year 28         51 117        86 271
year 29         54 184        93 173
year 30         57 435     100 627
year 31         60 881     108 677
year 32         64 534     117 371
year 33         68 406     126 760
year 34         72 510     136 901
year 35         76 861     147 853
year 36         81 473     159 682
year 37         86 361     172 456
year 38         91 543     186 253
year 39         97 035     201 153
year 40       102 857     217 245
year 41       109 029     234 625
year 42       115 570     253 395
year 43       122 505     273 666
year 44       129 855     295 560
year 45       137 646     319 204
year 46       145 905     344 741
year 47       154 659     372 320
year 48       163 939     402 106
year 49       173 775     434 274
year 50       184 202     469 016
Difference between 2% fee and no fee after 25 years until 50 year mark period.

I think the chart speaks for itself. The difference between a 2% fee and no fee is huge. Even if it sounded small at the beginning, if the time span is 50 years, the small difference will grow into a huge difference. Don’t know about you, but I would have some use to that extra 284 814 the fund with no fee would have gotten me.

Graph about the difference, orange representing no fee, blue representing 2% fee during 50 year time period with 8% annual return

Final words

The lesson of the story is next: Most of the times, maybe not always, but most of the times, passive index funds with low fees are the better option compared to active funds. Usually they are a better option than investing straight into stocks and trying to beat the market yourself as well. Unless you happen to be the next great investor of our time.

I have talked about this before. I personally use the strategy, where 80% of my money, what I put into the stock market, is in low cost index funds, the rest 20% I put into stocks of my choice. This will keep things interesting for me, when I can see how my own picks are performing.

It doesn’t really matter how the markets are performing. The difference will stay almost the same. I’m not saying all active funds are bad. Just that most of the time, especially in the long run, they cant beat the index. Because of this, unless you want to gamble and try to get the 1 out of 10 funds that will beat the index, it might be better to just stick with the low fee index funds.

This is not investment or financial advice. I’m sharing my own thoughts and I hope they can be helpful to you. Past returns of the market are not a guarantee of future returns. Always do your research before risking your hard-earned money.