Index Fund and Actively Managed Fund - Example

Introduction: This paper indentifies the advantages and disadvantages of an index fund, and an actively managed fund. This paper also identifies the differences that exist between these two funds. An actively managed fund involves activities whereby a portfolio manager tries to win over the market, by choosing and picking investments. The portfolio manager tries to perform an in-depth analysis of a variety of investments, for the main purpose of trying to outperform the financial market index. An example is the S&P 500. Portfolio managers on the other hand manage index funds in a passive manner (Blitz, Huij and Swinkels, 2010). A manager, who is involved in managing index funds, normally tries to imitate the returns of an index fund by purchasing a wide number of holding contained in the index under consideration. Investors can use a mutual fund, or even an exchange traded fund, for purposes of investing in an index fund. It is important to understand that investors are always in a dilemma on whether to invest in an index fund, or in an actively managed fund. However, most investors are always attracted to the idea of making quick returns through an actively managed fund, as opposed to an index fund. This is because when investing in an index fund, investors will only get the market return of their investments (Sharifzadeh and Hojat, 2012). However, evidence suggests that actively managed funds are unable to achieve consistency in outperforming the market index. For instance, research indicates that for the last 10 years, leading to the year 2007, most of actively managed funds in the United States managed to underperform in their respective index. Pros and Cons of an Index Fund: Pros: One major advantage of an index fund is that they have lower risks, and they present a steady growth. Index Funds are diversified, and they represent a variety of sectors that belong to an index. This in turn helps to protect an investor against deep losses. Scholars denote that index funds normally perform better than non-index funds, which always strive to outperform the market. For example, scholars denote that index funds which were tied to the S&P 500 index were able to generate good returns in for the three years before 2011 (Gastineau, 2010). This is when these funds were compared to the actively managed funds. Scholars estimate that the rate of the return for an index fund, over a long period of time is approximately 9%. This is when analyzing the S&P 500 index. Guasoni, Huberman, and Wang (2011) further denote that when inflation is factored in this percentage growth, then the rate of return of an index fund, over a period of time falls to 6%. Scholars denote that this is more desirable, to invest in an index fund, because chances of losing an investment is minimal, and investors are guaranteed of getting a return over a long period of time (Kacperczyk, Sialm, and Zheng, 2005). One major advantage of an index fund is the ability of such kind of a fund to keep its fees low, when compared to the non index funds. One major reason as to why these index funds have lower fees is pegged on the fact that index funds have limited transactions. On this basis, investors are not required to pay more for the services of the portfolio managers because funds only stick to a given portfolio. This lower fee is advantageous when compared to actively managed funds, which normally charge higher fees, but their rates of return are low, when compared to that of an index fund (Kirsch, 2005). The major reason as to why these funds normally stick to one index is based on the notion that any information concerning the stock is already depicted in the prices of the security or stock under consideration. On this basis, no individual investor or portfolio manager can beat the market. It is therefore wise for funds to stay in one index over a considerable period of time. This is cheaper, and an investor will be guaranteed of returns or profits. Another advantage that an index fund has is that an investor does not need any experience to invest in such kind of a fund. This is because an index fund does not need an investor to pick stocks, and very little knowledge on business is required (Ma and Zhang, 2010). An index fund also has the capability of making an investor to save on his time. This is because only little time is needed for an investor to make decisions concerning his or her investments. Cons: There are two major disadvantages of investing in an index fund, and they are, lack of flexibility, and lack of making big profits. Investors who invest in an index fund luck flexibility because an investment must be undertaken within the constraints of having to match the returns of the index under consideration (Blitz, Huij and Swinkels, 2010). For example, when the returns of an index are strongly declining, managers of the index fund have little options that they can undertake for purposes of reducing the losses. In contrast to this, managers of an active managed fund have many options of limiting the loss, and this can include investing in a stock that performs well. Another disadvantage is that these funds do not have the capability of outperforming the market. On this basis, the rates of returns of these investments are always low as compared to actively managed funds, which have the capability of outperforming the market. Pros and Cons of active managed funds: Pros: The main advantage of an active managed fund is that it makes it possible for investors to select a number of investments, apart from making an investment, in the whole market. Investors normally have the following motivation when deciding to use actively managed funds (Blitz, Huij and Swinkels, 2010), They believe that some segments of the market are less efficient when it comes to creating profits, when compared to other segments of the market. They are able to manage volatility of their investments, and this is by investing in high quality companies, which have a stable business operation, as opposed to investing in the whole market. There are opportunities of making very high profits through their investments. It makes it possible for investors to have a wide knowledge of the security market, and various indexes, and on this basis, an investor can make a good decision on where to invest his or her security. There is no flexibility in these investments, and on this basis, an investor can decide to invest in indexes that are profitable, and mitigate on the losses of indexes that are not profitable. Cons: One major disadvantage of an actively managed fund is that chances are high that an investor can make bad investment decisions. This may definitely lead to heavy losses by an investor. The fees charged in an actively managed fund are also high; this is when they are compared to the fees charged by an index fund. These fees are high, even if an investor does not frequently make some investments (Rompotis, 2011). It is therefore important for anyone wishing to invest in an actively managed fund to carefully examine the various fee requirements of this investment, if they wish to make any gainful returns from their investments. This is based on the fact that an investor might make small returns, only to be taken away by the fees that the portfolio manager chargers the investor. Another disadvantage is that these investments normally have an income tax impact, especially where there is a capital gain that emanates from the frequent trading activities. It is also important to understand that another disadvantage of an actively managed fund is that when it becomes too large, the fund begins to take the characteristics of an index fund. This is because investors must diversify their investments as opposed to limiting the investments to the ideas of the fund manager (Rompotis, 2011). However, most actively managed funds normally close their operations before reaching this point. This normally brings a conflict of interest between the portfolio managers and investors, because closing the funds would mean that there is a loss of income to the management, in terms of the fees charged. Advantages of Index Funds over Actively Managed Funds: From the analysis above, it is now possible to denote that an index fund is more beneficial when compared to an actively managed fund. The following are the major advantages of an index fund, as compared to an actively managed fund (Masterson and Wilchusky, 2010); The Portfolio Advantage: Index Funds normally have higher chances and probability of outperforming actively managed funds, when they are put together in a portfolio. Time Factor: Over a long period of time, Index Funds are more profitable when compared to actively managed funds. The Diversification disadvantage: Actively managed funds normally perform poorer when compared to an index fund when they are diversified. This is because an active managed fund seeks to gain shorter term interests, as opposed to an index fund whose funds are invested over a long period of time. Conclusion: In conclusion, it index funds normally generate a high rate of return, when they are invested over a long period of time. Actively managed funds on the other hand normally generate high income over a shorter period of time. However, as research indicates, these funds are not consistent in achieving returns. On this basis, investors rarely make money from this type of investments. It is also important to understand that in an actively managed fund, investors will always pay very high fees for their investments. This contributes to a great extent on the kind of returns that an investor manages to get. An index fund on the other hand is cheap to operate, and investors are guaranteed a return of their investments, when they invest it over a long period of time. Bibliography: Blitz, D., Huij, J., & Swinkels, L. (2010). The Performance of European Index Funds and Exchange-Traded Funds. European Financial Management, 108, 124-159. Gastineau, G. L. (2010). The exchange-traded funds manual (2nd ed.). Hoboken, N.J.: Wiley. Guasoni, P., Huberman, G., & Wang, Z. (2011). Performance maximization of actively managed funds. Journal of Financial Economics, 101(3), 574-595. Kacperczyk, M., Sialm, C., & Zheng, L. (2005). On the Industry Concentration of Actively Managed Equity Mutual Funds. The Journal of Finance, 60(4), 1983-2011. Kirsch, C. E. (2012). Fundamentals of mutual funds and exchange-traded funds, 2012. New York, NY: Practising Law Institute. Ma, H., & Zhang, W. (2010). Development of Actively Managed Exchange Traded Funds and the Revelation to Chinese Financial Market. International Journal of Financial Research, 1(1), 307-324. Masterson, P., & Wilchusky, S. (2010). Actively Managed Exchange-Traded Funds. The Journal of Index Investing, 1(1), 90-94. Rompotis, G. G. (2011). The Performance of Actively Managed Exchange-Traded Funds. The Journal of Index Investing, 1(4), 53-65. Sharifzadeh, M., & Hojat, S. (2012). An analytical performance comparison of exchange-traded funds with index funds: 2002–2010. Journal of Asset Management, 13(3), 196-209. Read More