Mutual funds can be classified as either index funds or active funds. Index funds attempt to replicate the performance of a benchmark index by owning the same securities as the index in the same proportions as the index. Active funds attempt to perform better than a benchmark index by owning specific securities that may or may not be included in the index but are expected to perform better than the index as a whole. Both types of mutual funds have proponents who will argue their advantages. Proponents of index funds will say three advantages of index funds are convenience, consistency, and cost-efficiency.

Index funds are very convenient for investors who prefer not to spend a lot of time and resources trying to determine which mutual funds to buy and sell. Investors decide which segments of the market they want own and then buy and hold index funds that track those segments. This eliminates the need to evaluate all the active fund offerings of multiple companies to select which fund might perform best in a category. Instead of analyzing mutual funds, index fund investors rely on the benefits of diversification and allocation. Diversification within a category is easy to achieve with index funds because they typically own most if not all of the securities that comprise a category. Rather than determining which categories to overweight or underweight, index fund investors can get market performance by simply allocating their portfolios to match the percentages each category represents of the overall market. Risk levels can be easily controlled by adjusting the allocations between stock index funds and bond index funds, and occasionally rebalancing among those index funds will allow investors to maintain their desired allocations.

Index funds consistently provide the average performance of a category because they always own a representative sample of all the securities in a category. The investment return of an index fund will resemble the aggregate return of all the securities that comprise that index. The securities owned by active funds may not fully represent the category, so their returns can be very different and inconsistent from the average returns of the category. When active funds in pursuit of better performance buy securities outside of their benchmark category, this changes the style and composition of the funds. Index funds are consistent in their style and composition because they will only own the securities that are included in the benchmark index. As a result, index funds have little risk of performing worse than their category benchmarks. Index funds appeal to investors who seek investment returns that are consistent with the returns of their targeted categories.

Index funds are cost-efficient because they do not require a lot of management labor. Index fund managers simply buy and hold shares of the securities that are included in the benchmark index. Active fund managers must research and monitor securities inside and outside of the index to determine which to buy and sell for their funds. The active fund managers ensure they are compensated for this additional work by charging higher expenses, thereby passing along extra costs to investors. In addition to higher fund expenses, investors may incur more tax costs with active funds. As active managers buy and sell multiple securities attempting to perform better than an index, they increase their funds’ turnover ratios, which increases the frequency of realized capital gains. Index funds buy and hold the same securities as long as they are included in the index, so index funds typically have lower turnover ratios and fewer capital gains tax liabilities.

Index fund investors follow a certain philosophy about investing. They believe active funds are inconvenient to analyze and monitor, inconsistent in composition and performance, and inefficient regarding costs. They believe the probability of an active fund performing better than a benchmark index does not warrant the acceptance of those disadvantages. They believe index funds are superior because they are convenient, consistent, low-cost investments, and maybe the biggest advantage of index funds is performance. Data from Standard & Poor’s Index Versus Active scorecard shows index funds have historically performed better than a majority of their active fund peers.