Actively Managed Funds vs Passive Index Funds - Research Proposal Example

Actively Managed Funds Vs Passive (Index) Funds

Abstract

This paper explores the significance of active managed funds and passive (index) funds and which is better for the investors for making investment. Quantitative research method would be incorporated in the paper to acquire the data from the selected sample on which investment management strategy is better for them. Therefore, survey would be useful in carrying out the research and collecting the required information. On the other hand, from the literature review it has been known that passive funds have some edge over the actively managed funds. However, limited researches are conducted in this area.

Table of Contents

1. Introduction4

2. Research Question4

3. Research Objectives4

4. Literature Review4

4.1 Active Managed Funds5

4.2 Passive (index) funds5

4.3 Measure the performance and Liquidity6

4.4 Comparison between active and passive managed funds7

4.5 Modern Portfolio Theory8

5. Research Methodology8

5.1 Research Philosophy8

5.2 Research Approach9

5.3 Strategies9

5.4 Choices9

5.5 Data Collection10

6. Ethical Consideration10

7 Time Horizons10

8 Resources11

Reference List12

• 1. Introduction

The quality management of a fund is a key constituent for ensuring successful operation in all economic endeavours. Financial advisors have a range of opinions when the investor is in the middle to decide whether the money is to be invested in actively managed fund or passively managed funds (Redhead, 2008). Different investors have their own choices on how they want their fund to be managed in a given situation. It is often discussed in the empirical studies that the investors face loss when they are not aware about the risk associated with the fund management strategies (Vanguard, 2016). In this paper, a research proposal would be developed on the significance of active managed funds and passive funds and to know a better strategy between the two for managing investor’s funds. Therefore, the gaps in undertaking both the investment management tools can be studied. In relation to that literature review and probable research methodology would be outlined as well.

• 2. Research Question

Which is the better investment management strategy between passive funds and actively managed fund for the investors?

• 3. Research Objectives
• To determine which is more effective for investment between passive (index funds and activity managed funds
• To ascertain the merits and demerits of actively managed funds
• To study the advantages and disadvantages of passive (index) funds
• 4. Literature Review

In this section, significant literature about the selected topic would be shown and a critical discussion would be provided from the same. Therefore, based on key concepts, theoretical research and empirical studies, the literature shall be drawn which would help in carrying the research work in depth manner.

• • 4.1 Active Managed Funds

It is an investment strategy which is based on utilising research for selecting particular binds or stocks to construct a portfolio. Active managers evaluate everything from firms’ finances to industry situations and the status of the entire economy so that their selected security can lead to spot investments that would beat the market (Spdru, 2016). As a result, an active large-cap equity fund would hold fifty to two hundred of what the manager deem to be most striking firms in the S&P 500 Index, with the aim of surpassing the index. However Jones (2009), pointed that as the stocks and bonds are traded more often and research is needed for identifying the appropriate investments then the costs for active funds tend to be more.

On the other hand Shankar (2007), stated that actively managed funds are those that are managed by a team managers or an individual manager. Active management comprises exchange-traded funds and mutual funds along with portfolio of bonds and stocks which are managed by financial advisors. One of the advantages of using active management is that the experts would be taking decision on behalf of the investors which can ensure higher return on their investments. Further, Wharton (2016) pointed that active managers can be flexible in the approach as they are not required to own any specific bonds or stocks. It is also mentioned that the using active managed funds, the investors can diversify their portfolio with a range of funds and can also access to various types of assets.

According to Mose (2014), actively managed funds could bear higher fees to the investors as the funds are being managed by the fund or team manager. It is also mentioned that active management would not perform better in bear markets and would also not allow the investors to evade any potential losses. Moreover, the active investors could be facing risk like trading costs, dilution from holding higher cash positions, higher commissions and taxes in taxable account because of high turnover rates. Therefore, it can be indicated that such drawbacks of the actively managed funds can restrict a potential investor to consider it.

• • 4.2 Passive (index) funds

It is passively managed and depends on the conception that the market is efficient and stock would always operate at a fair price which might reflect all available market data/information. Therefore, the passive manager would not look into the individual firms or securities. According to Hebner (2006), a passive fund manager holds all the bonds and stocks in a specific market and they do not invest by tasking personal judgements or analysing market forecasts. Thus, an index fund or a large-cap passive fund can hold all 500 stocks in the S&P 500 Index as the manager only makes adjustments to the fund for reflecting changes in the index. On the other hand Wharton (2016), stated that very low fees are associated with the passive funds as there is no requirement to assess the securities in the index. It can be indicated that the passive investors makes their own decision whether to buy or sell the stocks in a specific market. Moreover, the investors would know that at all times what bonds or stocks are contained in an indexed investment. It is also opined that as the buy and hold style of index fund does not ensure high annual capital gains tax then it act as tax efficiency for the investors. Example of index fund is the Russell 2000 index and the Vanguard 500 Index fund. According to the recent release from the Indexing: the Long-Term View on Investing, it has been found that most of the active funds have underperformed indices.

As per Kukreja (2016), the index funds track an index or a target benchmark rather than searching for winners which supports in bearing lower operating costs and lower fees in contrast to actively managed funds. It is also mentioned that by tracking an index, a fund would all the time ensure returns in line with the overall sector or market performance. However, it is pointed that in the passively managed funds there could be risks as well. As the entire market is tracked by the index funds; therefore if there is fall in the overall bond prices or stock then there would be decline in the index too (Roth, 2010). Due to this, the investors may suffer loss. On the other hand, the index fund managers are often forbidden from employing defensive measures like moving out of shares even if they believe that the share price would go down.

• • 4.3 Measure the performance and Liquidity

In both the types of managing funds, active and passive, the performance is measured by how much return is received by the investors after a set period of time. It is studied that as the individual manager seeks to outperform market index then the index is set as a benchmark by the managers so that the investors can earn higher return. However, if the market is not in favour then it may limit the performance of managers to outcast the market (Redhead, 2008). On the other hand, in case of passive investment, the investors focus on matching the performance of market in order to gain expected future return.

Further, the success rate is calculated which indicate that the amount of actively managed funds which generated returns in excess of those produced by the average passive fund in the same period. This helps in measuring the performance of both the funds. According to the report of Morningstar, it has been found that despite of mixed performance in the recent years, the more capital has moved to passively managed funds in 2014-2015 than actively managed funds. In 2015, the investors have invested $413.8 billion in index funds which marked a withdrawal of $207.3 billion from the mutual funds. Also, in 2014, passive US equity fund inflows were $166.6 billion (Krouse and Driebusch, 2016).

On the other hand, it has been discussed that a lack of liquidity in the market may not be an issue for the investors as the active management maintain large cash position in comparison to passive investors. Moreover, the cash in the bonds can be reinvested which are liquid at any point of time. In consideration to that; Kukreja (2016), pointed that advantage of liquidity is also provided by the passive funds to the investors being as a low-cost investment option.

• • 4.4 Comparison between active and passive managed funds

According to Dunn (2011), active managers attempt to select stocks/securities that would outperform the market, therefore; they gamble across comparatively few securities. Due to this, if an active manager takes wrong decision then they would significantly underperform the market averages. On the other hand, it is mentioned that passively developed portfolios could be more diversified and would enclose thousands of shares/securities which is allocated among different investment groups. It has been found from the earlier research that asset class diversification with index funds and passive funds generate more returns with lower volatility.

It is opined by Swensen (2009), that in passive fund, tracking an index would not be safer for the investor as the funds match the upswing in a bull market and money is lost by the investors in a down cycle as they remain stick to the index in spite of taking action to decrease risk. It is also mentioned that in certain niche markets, where assets are less liquid, it would be difficult for investors to buy securities or they might try to avoid such market but it is not same in the case of active managed funds. Thus, the active manager can spot an opportunity to generate return.

• • 4.5 Modern Portfolio Theory

It is the theory which was pioneered by Harry Markowitz. The theory presents a notion that how risk-averse investors can develop portfolios for maximising their expected return. It has been discussed that constructing an efficient frontier of optimal portfolios can offer maximum potential expected return to the investors for a given risk level (Markowitz, 1952). Moreover, it is mentioned that by using this theory, the investors can decide whether actively managed funds or passive funds would ensure better return with less risk in a particular period. According to the assumption of Modern Portfolio theory, the stock markets are efficient, therefore; no investor, manager or analyst is able to use the information which may allow them to outperform the market of other investors over the time. Moreover, it is also assumed that investors are rational in making investments decisions (Elton et al. 2009). Thus, it can be pointed considering the theory, passive management is more efficient and could provide better return as the passive managers do not look to perform better than the market. However, it is argued that as the active manager does not believe market is completely efficient all the time then those inefficiencies could be capitalised by searching the investments in the market which is undervalued.

• 5. Research Methodology

This section would be useful in evaluating the methods which can be employed for meeting the objective of the research study. The researcher would be able to outline the methods which could be employed for collecting information regarding passive and actively managed funds.

• • 5.1 Research Philosophy

This philosophy would be effective in the accumulation of beliefs which shall be linked with the truthiness of the materials being scrutinised. Also, an assumption would be developed which could support the research work in best possible way (Kumar, 2014). The research philosophy consists, positivism, realism, interpretivism and pragmatism.

For this research study, positivism philosophy would be appropriate. It would support in determining the link between the passively and actively managed funds and to know which fund can be most effective for the investors to generate better expected return.

• • 5.2 Research Approach

It would be consider by the researcher for collecting the information from external source or developing new concepts based on the previous studies. This method comprises deductive, inductive and abduction approaches (Bergh and Ketchen, 2006).

Deductive approach shall be used for the research study. Based on the existing concepts or theories, the researcher would be able to develop hypotheses and which can thereby be inspected for measuring the constructed hypotheses. Therefore, the existing information on the active and passive funds can be utilised for developing the hypothesis.

• • 5.3 Strategies

For collecting the required information, the researcher would have to consider developing research strategies. In context to that, archival research strategy would be used in the research study as through this the opinion of the investors and fund managers and what risks are faced by them can be known when using either of the two managed funds strategies. Therefore, existing archive documents or data sets would be accessed for collecting information. It can be effective in acquiring the information that would inform which investment management strategy can be beneficial for the investors to gain expected return.

• • 5.4 Choices

Under this stage, the researcher would select method which can help in collecting data either quantitative or qualitative. Therefore, the researcher would be using mixed method for this research paper as it would allow him/her to examine and evaluate the data simultaneously (Kumar, 2014). It would be helpful in understanding the underlying opinions of people, based on the theoretical and statistical data. Also, a connection would be studied between dependent and independent variables.

• • 5.5 Data Collection

In this method, the data would be acquired through secondary research. Earlier researches on the passively (index) funds and actively managed funds would provide the required information, which would be further analysed in this research study. In context to that, the relevant sources shall be used to collect both statistical and theoretical information. Therefore, trends in the use of passive funds or active managed funds would be analysed to determine that, over the time which investment management fund has shown growth and has been accepted by the investors.

• 6. Ethical Consideration

For carrying out the research study, ethical code of conduct would be maintained. The participants would be completely informed about the purpose and nature of the study. Also, the voluntary participation would be sought. No individual would be pressurized to give their opinion. On the other hand, the research would be carried out only for academic purpose and as an original piece of work. Thus, during the research study, it shall be maintained that there is no plagiarism issue.

• 7 Time Horizons

Table 1: Gantt chart

Activity

Week 1-2

Week 3-4

Week 4-5

Week 5-6

Week 7-8

Week 8-9

Week 9-10

Selection of topic

Identification of research area

Preparation of research proposal

Conducting Literature Review

Collection of secondary data

Analysis of secondary data

Conducting survey

Evaluating the response of the survey questionnaire

Analysing and comparing the results of the primary and secondary research

Preparation and submission of final report

Source: Author’s Creation

• 8 Resources

The researcher would require resources for collecting the information from different sources. It is known that if there is shortage of required resources then it would be difficult in completing the research work in set time period (Chawla and Sodhi, 2011). One could require either direct costs or indirect costs. For this research paper, the researcher shall consider indirect costs such as using databases, journals and books for accumulating the valuable information on the passive funds and actively managed funds. Also, time management need to be valued by the researcher for completing the research work in expected time.

• Reference List

Bergh, D. and Ketchen, D., 2006. Research Methodology in Strategy and Management. UK: JAI Press.

Chawla, D. and Sodhi, N., 2011. Research Methodology: Concepts and Cases. India: VIKAS Publishing.

Dunn, J., 2011. Share Investing. China: Wiley.

Elton, E., Gruber, M., Brown, S. and Goetzmann, W., 2009. Modern Portfolio Theory and Investment Analysis. Delhi: Wiley.

Hebner, M., 2006. Index Funds. China: IFA Publishing.

Jones, C., 2009. Investments: Analysis and Management. USA: John Wiley & Sons.

Krouse, S., and Driebusch, C., 2016. Investors Snub Money Managers for Market Clones, The Wall Street Journal. Available at: <http://www.wsj.com/articles/morningstar-says-actively-managed-mutual-funds-saw-outflows-in-2015-1452701873> [Accessed 14 Jun. 2016]

Kukreja, A. 2016. Active funds v/s passive funds; which one wins and when?. [online] Moneycontrol.com. Available at: <http://www.moneycontrol.com/news/mf-experts/active-funds-vs-passive-fundsone-winswhen_974967.html> [Accessed 14 Jun. 2016].

Kumar, R., 2014. Research Methodology: A Step-by-Step Guide for Beginners. India: Wiley.

Markowitz, H. M., 1952. Portfolio selection. The Journal of Finance, 7(1), pp. 77-91.

Mose, A., 2014. Actively managed funds – Do they add value?. [online] Studenttheses.cbs.dk. Available at: <http://studenttheses.cbs.dk/bitstream/handle/10417/4846/alexander_pahlow_mose.pdf?sequence=1> [Accessed 14 Jun. 2016].

Redhead, K., 2008. Personal Finance and Investments: A Behavioural Finance Perspective. London: Routledge.

Roth, J., 2010. Your Money: The Missing Manual. USA: O'Reilly.

Shankar, S. G., 2007. Active versus passive index management: A performance comparison of the S&P and the Russell Indexes. Journal of Investing, 16(2), pp. 85-95.

Spdru., 2016. A NEW MIDDLE GROUND: In the Active versus Passive Debate. [online] Available at: <ttps://www.spdru.com/content/a-new-middle-ground-in-the-active-versus-passive-debate> [Accessed 14 Jun. 2016].

Swensen, D., 2009. Pioneering Portfolio Management. New York: Free Press.

Vanguard., 2016. Investment risk and financial advice. [online] Available at: <https://www.vanguard.co.uk/documents/adv/literature/investor-risk-profiling.pdf> [Accessed 14 Jun. 2016].

Wharton, 2016. Active vs. Passive Investing: Which Approach Offers Better Returns?. [online] Executiveeducation.wharton.upenn.edu. Available at: <http://executiveeducation.wharton.upenn.edu/thought-leadership/wharton-wealth-management-initiative/wmi-thought-leadership/active-vs-passive-investing-which-approach-offers-better-returns> [Accessed 14 Jun. 2016].