Some investors pay higher management fees to investing in actively managed mutual funds for potentially higher returns. Other investors believe that passively managed index-tracking funds can deliver better returns, because index funds are cheaper in investment costs due to lower management fees and tax efficiency from little portfolio turnover. Although actively picking stocks might or might not beat the market, index fund returns are also dependent. Index fund returns are affected by how funds select what index to track when picking different stocks and assigning corresponding weights in order to construct portfolio compositions. Evaluating index fund returns involves comparisons against historical rates of return and performances from funds of similar categories, as well as broad market benchmarks.
The key to evaluating any fund returns is to focus on the relativity of the results. Meaningful performance numbers are all relative and should be analyzed within relevant investment groups. When an index fund does not strictly track a broad market or an existing index, it can go through portfolio rebalancing over time by adjusting the make-up of its index, adding some companies and dropping others. Therefore, current returns should be compared to past returns to reflect any change from index modifications along the way. Of course, performances can also change because of the up-and-down nature of the general market.
Mutual funds come in many categories with different investment strategies. When evaluating index fund returns against those of another actively managed fund, the two funds must be comparable in terms of their investment focus. For instance, returns from an emerging market, growth index fund might outperform a value-focused, active fund from the United States. At the same time, however, the same index fund might have underperformed an active mutual fund in the same emerging market, growth category. To avoid misleading index fund investors, comparison of index fund results must be fair and appropriate.
An index fund that strictly tracks a benchmark index might not beat the market after subtracting management fees and other fund costs from the fund returns. To improve fund performance, many funds try not to replicate a market index on a 100 percent basis or instead design their own index based on a particular investment scheme for certain sectors and industries. As portfolio construction for an index fund deviates from a total market index composition, the risk prospect of the index fund relative to the benchmark index changes. Therefore, index fund returns should always be compared to a relevant market benchmark in order to determine whether a particular index fund has outperformed or underperformed the market in general.