Actively Management versus Index Fund - Essay Example

Insert Actively Management versus Index fund Number Department Actively Management versus Index fund An actively managed fund is an approach to portfolio management whereby the managers engage in strategic investments with the aim of generating returns surpassing the investment benchmark index. The strategy enables investors to anticipate gains that are closely similar to that of investment weighting resulting from an index fund investment. On the other hand, Index Fund involves a mutual investment strategy that is geared towards generating returns which reflect the behaviour of an index of a particular financial market (Long, 2011). Alternatively, an Index Fund may be determined by a set of permanent regulations guiding ownership, irrespective of market forces. Either way these investment funds save the shareholders the headache of running their own portfolios. Advantages of actively managed funds Firstly, the main benefit of actively managed fund is that it is flexible in terms of viable investment options (Fama and French, 2010). The fund avoids blanket investment in the market and enables investors to exercise their scepticism of the appropriate market forces or hold the belief that a number of market sectors are less viable than others, before settling for the most viable option. In addition, actively managed funds provide investors the opportunity to control volatility in the market by putting their investments in less-risky, stable companies that may have slightly poorer returns on a temporary basis (Elton, and Gruber, 2010). However, a number of investors often show interest in investment options with additional risks in return for gains that exceed the ordinary market rates. Secondly, different investment portfolios which are diverse to the market under actively managed funds help to keep portfolio risks to bare minimum. As Long (2011) has suggested, investors who may desire a strategy that deters or underweights particular industries in relation to the entire market would also get a reprieve and find the fund as more in keeping with their own unique goals of investment (Israelsen, 2010). An individual working in a company in one sector who benefits from company stocks, for instance, will have the option to invest the additional funds in a different sector. Disadvantages of actively managed funds Firstly, actively management is disadvantageous because in the event that a manager makes a wrong investment decision, the whole portfolio may become a cropper (Anderson and Ahmed, 2005). Secondly, the costs related to active management are higher than those that index fund managers part with, even if regular trading activities are unavailable. Thirdly, recent data suggest that the bulk of actively managed high and mid-cap stock funds in the United Kingdom are less viable than index fund investments (Long, 2011). In addition, active fund management approaches that revolve around frequent trading create higher transaction fees which in the long term negatively impact the gains obtained from the fund (Israelsen, 2010). In light of this, the temporary capital gains generated by frequent trade of securities usually attracts higher income tax when the returns are deposited in an account that attracts such levies. Lastly, an extremely large asset base under an actively managed fund forces the manager to diversify the investment decisions to an index-like arrangement (Xie and Huang 2013). This change of tact is normally influenced by the need to invest in diverse, ever-expanding portfolios which the managers believe will yield the most secure returns. Several organizations specialized in mutual fund investments close their funds when they are convinced that they should not absorb any more capital; but this is normally not the ultimate remedy as the need to keep the mutual fund under control will always conflict with the interest of the shareholders who look forward to better returns on their investment (Anderson and Ahmed, 2005). Advantages of Index Funds Firstly, index funds are advantageous because they require lower costs to manage and are more ideal for individual investors (Elton, and Gruber, 2010). The easier process of marking the target index brings out a sense of stability and consistency in the whole affair. In addition, the high cost of maintaining stock pickers does not arise (Anderson and Ahmed, 2005). Meanwhile, the investment goals of index funds are straightforward and easily understandable. Immediately an investor has identified the target index, the securities the management will hold becomes clear. Secondly, the turnover rates involving trading of securities by the management are normally kept at bare minimum (Fama and French 2010). As such, the strategy saves investors additional costs in the taxes on the sale of securities based on gains. In some cases, such charges are spread to the investors in a fund. Even if investors and the general management of such funds are exempted from taxes, there are normally direct and indirect charges for actively managed funds, which negatively impact gains on a pound-for-pound basis. Thirdly, owing to the passive investment nature of index funds, the turnovers are remarkably more sustainable than actively managed funds. Anderson and Ahmed (2005) point out that for almost two decades now, investors are known to keep less than half of the cumulative gains of the actively managed mutual fund on average as compared to more than four-fifths of the same capital in index fund. This heavier investment in index fund is attributed to its consistency. Fourthly, the stability so established in index fund prevents cases of drift of style which are common in actively managed funds. Style drift takes place when actively managed mutual funds exceed the parameters set up in the style; for instance, index funds would keep a mid-cap value within the operational parameters set for secure returns (Xie and Huang 2013). In light of this consistency, index fund is immune to any negative impacts on portfolios whose construction is based on diversification of investment options. Elton and Gruber (2010), argue that drifts to other styles have the potential to limit the general portfolios diversity and eventually increase chances of volatility of the investments in an actively managed fund. Nonetheless, index funds do not provide room for such drifts and therefore increases the chances for diversifying a portfolio. Disadvantages of index funds Firstly, index funds lack the flexibility in choosing investment portfolios and the modest gains for the shareholders (Israelsen, 2010). Owing to the massive obligation of index fund managers to adhere to the rules and measures that require them to remain productive under lockstep conditions, their hands are virtually more tied as compared with the working conditions of their actively managed fund counterparts. Israelsen (2010) note that these conditions therefore limit investment options of index funds to those with corresponding index returns. Therefore, should there be a sharp drop in returns on an index the managers will have fewer options through which they can control those losses (Israelsen, 2010). Conversely, in actively managed funds, managers have a higher level of flexibility that they can try out before settling for the most viable options, irrespective of the market forces. Secondly, an index fund is disadvantageous because it registers modest gains and is not as viable as actively managed funds. This implies that individual investors in an index fund basically forfeit the likelihood of enjoying more handsome returns on their investment. According to Israelsen (2010), the top-performing funds in active management often yield better returns than the most active index funds in any given year. Regardless, the most viable non-index funds occasionally fluctuate on an annual basis. As such, the years that register dips in return can level can be neutralized by the performances which exceed optimum levels. Conversely, index funds register steady performance (Xie and Huang, 2013). Similarities and differences Actively managed funds The funds normally rely on somewhat different strategies of management (Israelsen, 2010). On the one hand, the managers in charge of actively managed funds normally capitalize on the market opportunities by making purchases of securities such as stocks whose values are lower than the standard marks. Alternatively, they may engage in short-term sales of high-valued securities to obtain handsome returns (Fama, and French, 2010). Managers normally use these strategies either singly or in a combination in order to achieve value for the investors. Based on the objectives of the particular investment portfolio, an actively management fund may be tailored to protect the investors from unpredictable market forces which could precipitate risks to the investors. Managing risks in an actively managed fund may substitute or add to the investment activities aimed at ensuring that the returns exceed the benchmark index (Elton, and Gruber, 2010). Index funds On the other hand, the primary concept behind Index Fund is the efficient-market hypothesis (EMH) (Long, 2011). The theory posits that managers of funds and stocks search for securities that are likely to weather adverse market conditions. As such, this rivalry is so real that almost new information relating to a company will reflect on the stock prices. Xie and Huang (2013) argue therefore that it is extremely hard to predict which company stocks will weather the sensitive market forces and outperform others. By establishing an index fund that fully reflects the entire market the problems encountered in stock selection become completely unheard of. Conclusion Actively managed funds and index funds provide investment opportunities for new and advanced investors who are preoccupied with other important activities in life other than managing the funds and investment portfolios. In light of this, index funds are better for individual investors because they will meet the primary goals of making such investment. Index fund is more appropriate to the average investor without modest financial resources to invest and it is stable. References Anderson, S., and Ahmed, P. 2005. Mutual Funds: Fifty Years of Research Findings. London; Springer. Elton, E.J., and Gruber, M.J. 2010. Investments and Portfolio Performance. London: World Scientific. Fama, E.F. and French, K.R. 2010. Luck versus Skill in the Cross-Section of Mutual Fund Returns. Journal of Finance, 65(5), pp.1915-1947. Israelsen, C.L. 2010. Twelve: A Diversified Investment Portfolio with a Plan. New York: John Wiley & Sons. Long, K. 2011. Asset allocation in a Bayesian copula-GARCH framework: An application to the passive funds versus active funds problem. Journal of Asset Management, 12(1), pp.45- 66. Xie, S., and Huang, X. 2013. An Empirical Analysis of the Volatility in the Open-End Fund Market: Evidence from China. Emerging Markets Finance & Trade, 49, pp.150-162. Read More