Actively Managed Funds and Index Funds - Essay Example

Actively Managed Funds and Index Funds Actively Managed Funds vs. Index Funds The term fund is used to refer to assets that are in form of money (cash). This document focuses mainly on two types of funds; actively managed funds and index funds. The former (also referred to as active investing) focuses on the active purchase and sale of stocks and bonds with the main aim being to beat the market. The activities of purchase and sale of these kinds of funds is effected by either a professional fund manager, professional co-managers or a group of professional fund managers, who consider a number of factors before engaging in any transaction. These factors include the political climate, prevailing market conditions, the economic status and company related factors, such as the market share and profitability. The determination of whether these factors are conducive or not is usually based on forecasting, the managers’ own judgment and conducting of the analytical research. The level at which investment in actively managed funds can return is highly dependent on the competence of the managerial team (Ali, H. & Chad, 405). Index funds (also known as passively managed funds) on the other hand can be seen as a collection of stocks bearing similar risk and return characteristics conquering with both specific and well outlined set of rules with regard to ownership, which do not change regardless of the prevailing market conditions (Choi, Laibson, Brigitte, 2010; pg. 1405-1432). Stock collection comprise of emerging markets, some companies from the Unites States of America and a good number of others being found in foreign countries. Discussed in the subsequent paragraphs are the advantages and disadvantages of the two kinds of funds. An individual investor weighs between the advantages and disadvantages of either kind of funds before deciding on which one to en entrust with his investments. Actively Managed Funds Advantages of investing in actively managed funds Outlined below are the reasons as to why an individual can find it suitable to invest in actively managed funds (Marcin, Clemens, Lu, 2005; pg. 1984) i. In case the individual investor lacks or does not have much information to enable him arrive at a viable decision, he can leave the task to the experts to accord him/her. This in a way gives the investor an assurance of high probability of getting returns than if he/she would risk doing something he is not sure of. ii. There is increased access to a vast number of markets, assets and various industry sectors. This presents a wide spectrum for the investors. iii. There is flexibility in that, the manager or team of managers contacts a survey to be sure that they invest in the best market opportunities. This is advantageous to the investors. iv. In case the team of managers finds out that the market is falling, it will work on shifting the share investment to elsewhere so as to minimize on the losses. v. Actively managed funds have the ability to perform better than index funds since their main objective is to beat the market. Disadvantages of actively managed funds Despite the notable pros outlined above, there are a number of downsides that come with this kind of investment (Klaas, Metric, Jessica, 2001; pg. 80). i. The fees charged here is high due to the management being under a team of managers ii. A good number of actively managed funds concentrate the investment in one region hence susceptible to failing to achieve the benchmark. iii. For every sale, there are associated taxes and fees to be incurred, hence reducing the performance of the fund iv. Unsuited to efficient markets – the more efficient the markets tend to become, the more difficult it gets for the managers of this kind of funds to beat the market. v. Irrespective of how the investor’s fund will behave (whether it flourishes or not), one is supposed to pay a flat fee, thus this may result in individuals suffering losses. Index/Passively managed Funds Advantages of investing in index funds i. Survives through the efficient markets – as the markets become efficient, index funds record a corresponding positive progression. ii. The low and affordable expense ratio is yet another add for index funds. This gives most individual investors a reason to consider this category of funds due to their affordability. iii. Still on expenses, index funds are passively managed. This infers that the management cost for the same is comparatively low with respect to those funds which are actively managed by a manager or even a team of managers. iv. Investors are given the chance of betting on the wider class of assets or market. The main reason behind this is the absence of security-specific threats, which may target one particular stock. v. There is ease of portfolio management through periodic rebalancing. This is due to reduced/no worry over specific fund performance. vi. Reduced management cost since the investment tracks a specific index and thus, it is needless to have an active management. Disadvantages of investing in index funds i. Absence of outperformance – compared to actively managed funds, it is not easy for the passively managed funds to beat the market (Choi, Laibson & Brigitte, 2010; pg. 1406). ii. Minimal options – the existing number of passive funds is not able to meet the current investment strategies that ought to be executed iii. Lack of flexibility – before making any move, managers of index funds have to go through various laid down policies and strategies. This is both a lengthy and complex procedure. The decisions made with regard to the funds must be arrived at bearing all the constraints of trying to match the index returns. iv. Diversification – some investors find it difficult to familiarize themselves with the stock due to the wide range of stock that the investment handles. v. This type of fund requires a longer period of time before it fully establishes. This time can take even up to as more as 15 years (Gruber, 1996, pg. 790). vi. There are lower returns as compared to the actively managed funds. After a clear understanding of both the pros and cons of either investing in actively managed funds or index funds, an individual investor would then decide to invest in one of the duos. However, there is a number of steps to be followed depending on the selected investment fund. Steps to be taken before investing in actively managed funds; i. Making the choice of the actively managed fund to invest in – due to the existence of the many actively managed funds available, it is important for one to make a proper decision pertaining the same. The potential investor is advised to choose a fund that deals in asset classes or industrial investment that he/she is familiar with. Having full information of the charges and fees to be incurred can also help one in knowing the right managed fund to choose. ii. The second step to take is the buying and selling of managed funds – investing in this kind of fund means an individual is purchasing the units/parts of the fund. The number of units to be given will depend on the price of one unit at the time of investment. The units are at a constant value; they are of equal value. Carrying out this steps requires the individual investor to know how an actively managed fund is bought and also be aware of his/her withdrawal rights. In addition to this, he/she ought to have some knowledge of the importance of investment diversification (Ali, Chad, 2004; pg. 418) iii. Track keeping by the investor – the law requires that an investor be updated at least once annually. Despite the fact that the team of professional managers will keep the investor updated with the relevant information, it is still necessary that the investor keeps track of his/her investment. This can be achieved through an investor carefully going through the performance reports send by the professional fund managers, identifying the undoing factors and finally, filing/safe-keeping of all the statements given. Steps to be taken before investing in index funds; i. Making the choice of the index – there are several index that an investor can choose from. Examples of the best index include the NASDAQ Composite Average, Dow Jones Industrial Average and the S & P 500. Other indexes may be found transacting in various economic segments such as health care, real estate and biotechnology. ii. Investor’s general approach – a given index may contain several indexes. The investor has the freedom of making a choice among the given range of companies depending on one’s preference of investment focus. However, the more the number of companies one invests in, the more the return to expect. iii. Decide on the amount of money to invest in a given company of the index depending on one’s own criteria. iv. Placement of the stock – purchase orders through competent/experienced stock brokers v. Finally, just like in the case of actively managed funds, one ought to keep track of the performance of the index funds (Taylor et al, 2006; pg. 67). As seen in the above set of advantages and disadvantages in the two types of investment, it is evident that the first kind of investment (actively managed funds) has more harsh investment requirements as compared to passively managed funds. However, in terms of returns, individuals who invest in the former tend to enjoy higher returns than their counterparts who invest in the other type. On the same note, though there is no significant amounts of returns as compared to actively managed funds, index funds can be beneficial to beginner investors or those who do not have sufficient capital to invest. Despite the higher returns witnessed in investing in actively managed funds, these funds rarely outdo index funds. References Ali, H. & Chad, S.,2004, Product Differentiation, Search Costs, and Competition in the Mutual Fund Industry: A Case Study of S&P 500 Index Funds, 119 (2), 403 – 456. Choi, J. J., Laibson, D. & Brigitte, C. M., 2010, Why Does the Law of One Price Fail? An Experiment on Index Mutual Funds, 23 (4), 1405 – 1432. Gruber, M. J., 1996, Another Puzzle: The Growth in Actively Managed Mutual Funds 51 (3), 783–810. Klaas, P. B., Andrew M. & Jessica W., 2001, Should Investors Avoid All Actively Managed Mutual Funds? A Study in Bayesian Performance Evaluation. 56(1), 45–85 Marcin K., Clemens S. & Lu Z., 2005, On The Industry Concentration of Actively Managed Equity Mutual Funds, 60 (4), 1983 – 2011. Taylor Larimore, Mel Lindauer, Michael LeBoeuf, 2006, The Bogleheads Guide to Investing, New Jersey: John Wiley & Sons Read More