Index funds vs active funds remains one of the greatest debates in investing. Surprisingly, over the past decade, only about 79% of active stock fund managers have outperformed their designated benchmarks. For bond funds, this figure rises to 92%. However, the picture can differ when examining different timeframes.
Recent data from the Australian market shows a different short-term trend. The S&P/ASX 200 gained 27.8% in the year ending June 2021, while actively managed funds recorded higher returns of 29.2% to 30.1%, with 55.7% of these funds outperforming the benchmark. Nevertheless, index fund investing proves more compelling over longer periods. When looking at five and 10-year timeframes, 75.7% and 80.8% of actively managed funds failed to beat their benchmarks, respectively. As of June 2024, 65% of Australian General Equity funds underperformed the index, with this underperformance increasing to 82% over a 10-year horizon.
Beyond performance, the choice between these investment approaches often depends on personal priorities. Active fund management might be more suitable for investors who prioritise specific values or strategies, such as ethical considerations or environmental filters. This guide breaks down the differences between index funds and active funds, examining their performance, costs, risks and suitability for different investor profiles in 2025.
Core Investment Strategy: Passive Investing vs Active
The fundamental difference between index funds vs active funds lies in their core investment philosophies. These contrasting approaches shape how investors build wealth and determine their long-term financial outcomes.
Index Fund Investing: Tracking the Market
Passive investing, exemplified by index funds, follows a straightforward strategy: match rather than beat the market. Index funds replicate specific market benchmarks such as the S&P 500 or ASX 200 by holding the same securities in identical proportions. This approach stems from the belief that markets are difficult to outperform consistently over time. Accordingly, index funds maintain a buy-and-hold strategy with minimal trading, focusing on long-term growth regardless of short-term fluctuations.
Recent trends show the rising popularity of passive investing. As of 2023, passive index funds had grown to approximately half of all U.S. fund assets, compared to just 21% in 2021. Additionally, index fund investments in Australia have expanded by 539% over the past decade, with assets exceeding AUD 202.90 billion by December 2024.
Active Fund Management: Beating the Market
In contrast, active investing involves a hands-on approach where portfolio managers actively select securities they believe will outperform the broader market. These professionals employ various strategies, including in-depth research, company visits, market timing, and proprietary trading algorithms to identify potential winners. Unlike passive managers, active investors can adjust holdings based on changing market conditions and exercise flexibility in their investment choices.
Active management offers several potential advantages, notably the ability to navigate specialised market segments. For instance, active managers generally perform better in less efficient markets such as fixed income, real estate, and emerging markets. Furthermore, during the 12 months through June 2025, approximately 33% of actively managed funds achieved higher returns than their index counterparts after accounting for fees.
Key Differences
These strategies differ mostly in their underlying assumptions regarding market efficiency. Rather than trying to outperform market returns, passive investment accepts them, which is consistent with efficient market theory. Conversely, active management operates on the premise that skilled investors can identify mispriced securities and capitalise on market inefficiencies.
Another significant difference involves costs and trading frequency. Index funds typically charge substantially lower fees (0.05%- 0.30% annually) than active funds (0.50%- 1.50%). This fee differential significantly impacts long-term returns—a AUD 152,899 investment growing at 8% annually in an index fund with a 0.2% fee would outperform the same investment in an active fund with a 1.7% fee by approximately AUD 108,558 over 20 years.
Performance Over Time: What the Data Shows
Performance data tells a compelling story in the debate on index funds vs active funds. Short-term figures often contradict long-term trends, creating a complex picture for investors seeking clarity.
1-Year Returns: Active Funds’ Short-Term Edge
Recent short-term data shows active managers occasionally outperform. In the year ending June 2021, Australian Equity General funds achieved returns of 29.2% to 30.1%, surpassing the S&P/ASX 200’s 27.8% gain. Indeed, 55.7% of funds in this category beat their benchmark. Similarly, first-half 2025 data revealed bright spots—particularly in fixed income—where Australian Bonds funds demonstrated continued strength.
5-Year and 10-Year Trends: Index Funds Lead
Despite occasional short-term successes, more extended periods consistently favour index funds. According to recent SPIVA analysis, over 5-year and 10-year timeframes, 75.7% and 80.8% of Australian funds failed to outperform benchmarks, respectively. Globally, this pattern holds true—only 21% of active strategies beat their index counterparts over the decade ending June 2025.
Among Australian Equity General Funds, underperformance rates reached 77.6% over 5 years and 85.4% over 15 years. Even more striking, 89% of Global Equity General funds underperformed over 5 years, rising to 96% over 15 years.
SPIVA Scorecard Insights (2025)
The 2025 SPIVA Scorecard presents a nuanced view across different markets:
- Australian Equity General funds showed a 71% underperformance rate in H1 2025
- Bond fund managers fared better, with only 46% underperforming in H1 2025
- Active managers typically performed worst in large-cap equities (only 14% beat the S&P 500 over ten years)
- Fixed income and smaller-cap segments offered better opportunities for active management, with 43% of high-yield bond funds outperforming over a decade.
First, persistence of performance remains elusive—SPIVA found 0% chance of a top-half fund in 2018 remaining in the top half through 2022. Simultaneously, fund survivorship presents another challenge, with approximately 64% of equity funds being shuttered or merged over 20 years.
Cost and Tax Efficiency Comparison
Beyond performance statistics, the cost structure of investment funds dramatically impacts wealth accumulation over time.
Expense Ratios: 0.05% vs 1.2% Average
There is a significant difference in the expense ratio between active funds and index funds. Passively managed index funds typically charge between 0.03% and 0.10% annually, whilst actively managed funds average 0.68%. Some passive options, like Vanguard’s S&P 500 ETF, charge merely 0.03%. This gap creates a significant compounding effect—a £100,000 investment growing at 7% in an index fund with 0.2% fees would reach £372,756 over 20 years, compared to £320,714 with a 1% fee active fund.
Capital Gains Distributions: Passive vs Active
Active funds generate more taxable events through frequent trading. With average portfolio turnover rates of approximately 80% annually (versus 10% for index funds), active funds inevitably create more capital gains distributions. In 2022, even during market downturns, 42% of active mutual funds distributed capital gains averaging 5% of NAV.
Tax Implications for Long-Term Investors
The buy-and-hold strategy of index funds provides superior tax efficiency. ETFs offer additional advantages through in-kind redemption processes, minimising taxable events. This efficiency becomes especially valuable for taxable accounts—studies show high-tax bracket investors received just 45% of pre-tax performance from active funds over a 30-year period. Essentially, index funds allow more wealth to compound undisturbed by taxation, creating a substantial long-term advantage.
Risk, Volatility and Diversification
Investing inevitably involves risk, although the type and magnitude of risk differ between passive and active strategies, creating distinct risk profiles for investors to consider.
Market Risk vs Manager Risk
Both investment approaches face risk, though from different sources. Index funds primarily expose investors to market risk—the inevitable fluctuations of the broader market that cannot be avoided or eliminated. As a result, passive investors automatically experience all market downturns. Active management, alternatively, introduces manager risk—the possibility that human portfolio managers make costly investing mistakes. Only 4.1% of professionally managed portfolios consistently outperformed their benchmarks over the 20 years ended 2022, illustrating the significant manager risk active investors face.
Diversification: Broad Exposure vs Targeted Picks
Index funds provide built-in diversification by tracking large indices across multiple sectors and companies. Consequently, this broad approach reduces company-specific risk. Active managers, in contrast, can focus on specific sectors or themes, offering targeted exposure but potentially concentrated risks. This concentration becomes problematic in market corrections when a few large companies dominate an index, creating what some experts call “fragility.” In practice, many investors blend both approaches—using index funds for core market exposure while adding active funds in less efficient market segments.
Volatility in Bear Markets: Who Holds Better?
Conventional wisdom suggests active managers navigate market volatility better than index funds, yet evidence consistently contradicts this belief. Throughout the 2020 COVID-19 sell-off, most active funds underperformed passive counterparts. Subsequently, during the turbulent first half of 2020, 45.16% of active large-cap funds underperformed their benchmarks. Even in 2022, amid elevated valuations, inflation, and recession fears, active managers struggled to provide meaningful protection. Data shows active funds’ performance in downturns is neither categorically better nor worse than index funds—their success rates fluctuate widely based on market conditions.
Conclusion – Index Funds vs Active Funds
The debate between index funds and active funds presents a clear picture when examined through multiple lenses. Performance data tells a compelling story – while active funds occasionally shine in the short term, index funds demonstrate overwhelming superiority over extended timeframes. This pattern remains consistent across markets, with 80.8% of Australian actively managed funds failing to beat their benchmarks over 10 years.
Cost differences between these investment funds prove equally significant. Index funds typically charge 0.03% to 0.10% annually, whereas active funds demand considerably more at 0.68% on average. This fee differential compounds dramatically over decades, resulting in major losses for active fund investors.
Ultimately, index funds provide a remarkably compelling case for most long-term wealth builders through their lower costs, superior tax efficiency, and consistent performance. Though active funds will undoubtedly continue attracting investors hoping to beat the market, evidence strongly suggests that patience, discipline, and embracing market returns through indexing remain the more reliable path to building wealth over time.
Are index funds or active funds better for long-term wealth building?
Index funds generally offer better long-term wealth-building potential due to their lower costs, superior tax efficiency, and consistent performance over extended periods. However, active funds may be suitable for specific market segments or investor priorities.
How do the costs of index funds compare to active funds?
Index funds typically charge much lower fees, with expense ratios ranging from 0.03% to 0.10% annually. In contrast, active funds average around 0.68% in fees. This significant difference can substantially impact wealth accumulation over time.
What does recent performance data reveal about index funds vs active funds?
While active funds occasionally outperform in the short term, index funds consistently show superior results over longer periods. For example, almost 80% of actively managed funds in Australia did not outperform their benchmarks over a ten-year period.
How do index funds and active funds differ in terms of risk?
Index funds expose investors to market risk but eliminate manager risk. Active funds introduce the possibility of human error in investment decisions. Historical data show only a small percentage of actively managed portfolios consistently outperform benchmarks over extended periods.