Differences between Actively Managed Funds and Index Funds - Essay Example

Financial Service Financial Service Actively managed funds refer to a type of investment fund which is normally traded on stock exchange. Actively managed funds can trade beyond benchmark indexes and is not easy for an investor to determine what the future portfolio will be made up of. Fund managers opt for securities bearing a certain objective, such as a given set of index or projected level of returns with assumption of aspect of the underlying risks (Kacperczyk et al, 2005; pg. 1984). This kind of mutual fund attract a higher rate of tax and expense ratios. Actively managed portfolios consist of bonds or shares traded by fund managers who are well versed, therefore buy and sell them with expectation of maximizing their returns. These fund managers invest in a specified area with certain objectives such as for growth or income to ensure maximization of shareholders’ wealth. They normally place an annual charge of 4% to 5.5%. An index refers to a group of stocks that is considered to be a representative of a particular market segment. They are a basket of securities of which their return are termed as the aggregate return of their components. In America, the S&P 500 (Standard and Poor’s 500) and Dow Jones Industrials are examples of indexes. Many investors tend to misread the principles of comparison but use of indexes is simple to understand. (MccClatchy, 2002; pg. 5). Index funds refer to stocks and other securities within a portfolio designed to track a particular set of indexes. These funds provide a relatively lower expense ratio but provide a wider scale of market exposure. Index funds could be established to match indexes such as S&P 500. They bear low expenses in relation to operation. This is a kind of passive investment as opposed to actively managed funds. (Hebner, 2006; pg. 34). When purchasing a security in an index fund, an investor purchases a share of securities in the portfolio in an index, since the fund holds securities as they are purchased, but any increase in value of an index signifies an increase in value of funds’ shares. A decrease on index value would also mean that the funds’ shares follow the same trend. There is a change in weight of an index only if there is buying and selling of securities. Index funds are usually traded on major stock exchanges. Advantages of index funds Index funds could be easier and provide many investors with the opportunity to maximize their wealth. Baird compares this to gambling and that every investor, just like in a casino, believes that he/she emerges to be the winner. The use of Index funds is not a means to ‘beat’ the stock market but to have its reflection. Index funds hadn’t gained popularity until mid twentieth century up to an extent where index fund theories won Nobel Prizes in Economics. (Baird,2009; pg. 18). Index funds also use less technical jargons like diversification, benchmarking and allocation that can be easily understood by the investors. This provide a less complex approach towards the trading of securities at the exchange market (Baird, 2009; pg. 18). Since index funds are passive investments, the issuing company, as well as the percentage of every stock held, tends to reflect the underlying index. The index can be a bond index, domestic index, international index or any other that has a well-defined combination of securities. These index funds have a relatively low management expenses in comparison to actively managed investment funds. The reason to explain this is that they normally do not involve research analysts and have low transaction expenses. It is also observed that they have low turnover and contents of index funds are relatively stable and hence, call for a single portfolio manager. (Dellinger, 2006; pg. 258) Disadvantages of index funds Firstly, in index funds, stock picking could be a challenge in investment as it may be unclear on which right stock to be picked on. This presents the opportunity lost on big returns on stock. Investors may be at a crossroad in relation to picking those securities that will maximize their returns. (Baird, 2009; pg. 18). Secondly, some index funds reflect market indexes on a wider scale, whereas others have only special features such as market trends in a specific industry, geographical places among others. However, this reflections may not be so exact owing to management fees. These reduce the expected returns and hence the index funds may not be in perfection to replicate actual indexes. Tracking error refers to the difference between such investment dung and returns on index. (Investment answers.com). Thirdly, the performance of index funds is not always reflective of the index. This is due to the fact that the index itself is a combination of unmanaged collection of securities. It does not replicate any administrative expenses. The index fund does not involve administration and transaction expenses and incase it does, the performance of the index funds will be considerably be lower that the index. (Dellinger, 2006; pg. 258) Advantages of actively managed First, actively managed funds have a greater chance to outperform index funds. There has been a poor performance of actively managed funds but there is optimism that actively managed funds can be marketed to the public, thus promising a successful future in gathering assets. (Ferri, 2011; pg. 5) Second, actively managed funds are of great benefit to the investors. This is because they charge less than open-end fund. The structure allows companies involved in such funds to reduce many client services and this consequently results in a great reduction on administrative costs. (Ferri, 2011; pg.5) Thirdly, actively managed funds offer the desired flexibility. Such investment funds permit investors to trade all daylong and incorporates short sales and purchases on margin. This is very efficient for the investors (Ferri, 2011; pg.5) Disadvantages of actively managed funds Firstly, these types of funds yield higher before-tax returns but the returns after tax are relatively lower. This is because of ongoing trading. It is therefore preferred to keep such funds in tax-free or tax-deferred accounts. Investing in actively managed mutual funds promises greater returns but it’s a risk taking venture. It is hence prudent to keep investments in bulk in index funds (Larimore, 2006; pg.87). Secondly, as a result of separation of powers between the owners and the managers who control the financial assets such as stocks, managers of actively managed funds are in conflict with the expectations of the investors and their actions should be in the investor interests. Such misappropriations are easily addressed in index funds as a result of less difficult monitoring of such performance. (Ali and Yano, 2004; pg.151) Thirdly, fund companies have a responsibility to disclose part of their holding each day for the actively Managed funds to properly function. A fund composition file is required by authorized investors. This file outlines the stocks for a creation unit. This is quiet hectic to managers since full disclosure can be a hindrance to a fund’s strategy. Managers are also known to hide their holdings and trade so as to give a wrong impression to competitors. Managers also show reluctance in adjusting the contents of the portfolio to evade the front-runners and this is a threat rather than a competitive advantage. (Klaas et al, 2001; pg.45) Differences between actively managed funds and index funds 1. Luck or skill. Situations where actively managed funds have overpowered index funds have been cited to sheer luck and not skills. Research has it that return on passively-managed dollar is higher than actively managed dollar. Studies indicate that close to 3% of active managers defeat an index in a 10year time span. (Hebner, 2006; iv). 2. Risk and return on the portfolio Actively managed investments offer greater risk but with a lower return in comparison with a diversified index fund. Requirements such as management fees, costs and taxes reduce the returns expected on the actively managed investments to the advantage of mutual fund managers, brokers etc. (Hebner, 2006; iv). 3. Peace of mind Towards retirement years, it is prudent for one to enjoy his/her financial wellbeing instead of relying on government or family aid. An efficient investment portfolio of index funds is better suited for this. This is attributable to its assured provision of peace of mind and security at such a time as compared to actively managed funds. (Hebner, 2006; v) 4. Diversification Hebner says that diversification is the investor’s best friend. This is true because investors are risk averse and will opt for a set of portfolio that seeks to offer high expected returns at lowest risk. Index fund is ideal for this, for instance, Index S&P 500 offers a risk of 10% with a risk of 50% two thirds of the year. Most effective index fund portfolios offer 14% rate of return and 15%risk for last 50years. (Hebner, 2006; iv) 5. Expenses involved The index being a combination of unmanaged collection of securities, does not replicate any administrative expenses. The index fund does not involve administration and transaction expenses and incase it does, the performance of the index funds will be considerably be lower that the index. This proves more suitable in comparison to actively managed funds. (Dellinger, 2006; pg.258) Having discussed the above advantages, disadvantages and differences in the two forms of investment, it is apparent that actively managed funds are not much friendly as index funds. Nevertheless, regarding returns, persons who invest in actively managed funds may benefit by realizing higher returns than investors in the index funds. Rationally, index funds can be advantageous to new investors or those who do not have adequate money to invest. References Baird, C. 2009, The Complete Guide to Investing in Index Funds: How to Earn High rates of Return Safely. : Publisher Publishing Company. Dellinger, J. K. 2006, The handbook of Variable Income Annuities, Volume 311 of Wiley Finance. : John Wiley & Sons. Ferri, R. A. 2011, The ETF Book: All You Need to Know About Exchange-Traded Funds. JOhn Wiley & Sons. Hebner, M. T. 2006, Index Funds: The 12-step Program for Active Investors. IFA Publishing, Inc. 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. 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. MccClatchy, W. 2002, Index Funds: Strategies for Investment Success. John Wiley &Sons. Paul A. U. Ali, K. Y. 2004, Eco-finance: The Legal Design and Regulation of Market-based Environmental Instruments. KLuwer Law International. Taylor Larimore, M. L.2006, The Bogleheads Guide to Investing. John Wiley & Sons. Read More