The difference between index and active investing starts with one fundamental decision: who decides what sits inside your portfolio?
With an index fund, the investment strategy is largely rules-based. The fund attempts to replicate the composition and performance of a chosen index, subject to tracking differences, expenses and implementation. If the index changes its constituents, the fund generally adjusts its portfolio accordingly.
With an active mutual fund, a professional fund-management team makes investment decisions. The manager may select securities based on valuation, business quality, earnings expectations, economic conditions, sector allocation or other investment criteria defined by the fund's strategy.
Active investing asks a different question: can a manager, after accounting for expenses, portfolio turnover and other costs, generate returns that justify the additional management and complexity?
Neither structure guarantees superior returns. An index fund will generally remain exposed to the index it tracks, while an active fund can differ substantially from its benchmark. The resulting experience for investors can therefore be very different even when two funds invest in broadly similar asset classes.