Actively Manged Funds vs. Index Funds

A mutual fund is an arrangement between investors who pool their money together. To manage the pooled money, they hire a professional money manager who makes (informed) decisions on buying and selling securities. In return for this service, the professional money manager takes an investment fee directly out of the assets of the fund each year. This fee, known as expense ratio, costs typically between 0.5% and 2.0% of the assets and comes directly out of your investments. Additionally, this fee also covers the administrative costs such as an office space, marketing costs, reporting costs, and more.

Depending on how actively the professional money manager is buying and selling securities, the mutual funds can be classified into two broad categories — actively managed and index mutual funds.

Actively Managed Mutual Funds

With actively managed funds, managers buy and sell securities with certain goals in mind. Typical goals are to beat a particular index or peer funds, or to achieve a certain level of return while minimizing risk.

To achieve these goals, the mutual fund companies place a lot of emphasis on expertise, experience, and discipline of the the fund managers and how successful they had been in the past.

But, at the end of the day, the fund managers are humans. Like all humans, they make errors for the shareholders of their funds such as:

• Deviating from the original objective of the fund


• Taking on more risk than stated in the objective of the fund


• Chasing performance after a hot stock


• Constantly buying and selling securities than necessary

Disadvantages of actively managed funds:

Expense ratio of actively managed funds is higher due to the costs associated with researching and analyzing attractive investments. Every stocks that comes in or goes out needs to be screened against the fund objectives and forecasting trends. To stay competitive and to beat indexes and peer funds, active managers typically trade more. And in doing so, they also incur higher transaction costs paid out as commissions and bid/ask spreads on their trades. When active managers take a profit by selling an investment, they also trigger capital gains taxes. There are inherent risks associated with being a human. The fund managers are subjected to human emotions related to risk aversion, risk taking, group thinking, and chasing performance. Read more about the Psychology of Active Trading.

Index Mutual Funds

An index fund is a type of mutual fund with a portfolio of securities constructed to match or track the components of an index, such as the S&P 500 or Russell 2000 index. An index fund is considered a passive investment because the fund managers are not actively trading securities, but rather, they are replicating all the companies found in the index they are tracking. This way if the index average goes down, the fund goes down. If the index rallies, so does the fund.

According to an article Index Funds Win Again — This Time By a Landslide by Dan Kadlec of TIME.

Investing is a zero-sum game. For every stock trade, there is a buy and a sell, representing a winner and a loser. For every investor that outperforms the market, another investor has to under perform. So in aggregate, investors are unable to beat the market because they are the market—half win, half lose. But the odds of winning are greatly enhanced through lower costs.One way to lower your fund costs is by investing in index mutual funds.

With an index fund, you are guaranteed for the average returns of the market the index is tracking. Most investors shoot for above-average returns, but most of them fail because 80% of the actively managed funds under perform their indexes and benchmarks. With an index fund, your fund costs are significantly lower because the mutual fund companies do not need to employ a slew of fund managers to do the research and analysis. Index funds are highly tax efficient because you do not realize capital gains taxes because of stock churning. With an index fund, you greatly minimize the risks associated with a fund manager.

Conclusion

All of the mutual funds I own are index fund. My goal is simply to ride the markets' ups and down. I take advantage of the down market by dollar-cost-averaging my purchases. I take advantage of the up markets by re-balancing the funds that have gone up to buy funds that are still lagging. This basically summarizes my investment strategy. It is not fancy. I do not track stocks or markets. It is very simple. That is why it is called Buy & Hold.