Indexing vs. Active Mutual Fund Management
Mutual funds come in many flavors, however, the basic dividing line between funds are index funds and actively managed funds.
These two types of funds reflect two very different philosophies about investing. Before purchasing a fund, you should know whether it is an index fund or an actively managed fund.
Both index funds and actively managed funds may have a place in your portfolio.
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History
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Mutual funds became available in the 1920s. Mutual funds didn't really take off until the 1960s, when they became the major alternative to investing in individual stocks.
Mutual fund shares represent ownership in a fund that owns many different stocks--thus providing diversity. Diversity protects small investors from losses that could occur from investment in only a few stocks.
The first index mutual fund, created by John Bogle at Vanguard, launched in 1976.
Market indexes track the performance of groups of stocks or the stock market as a whole. For instance, the Wiltshire 5000 tracks the performance of the complete U.S. market, including large and small company stocks.
Actively Managed Funds
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Most mutual funds are actively managed.
Active fund managers aim at careful stock selection to beat the market averages.
Actively managed funds believe that research and predictions about the economy may allow a fund manager to choose a group of stocks that will perform better than market indexes, such as the Standard and Poor's 500 (S&P 500). The S&P 500 is a market index of large company stocks.
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Index Funds
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Index funds seek to track a market index. Some indexes are quite broad, such as the Wiltshire 5000, others are more narrow, including indexes tracking emerging markets (markets in Third World countries).
Index funds are managed to mimic various stock market indexes. Index funds don't try to surpass the market but to equal market performance.
The theory behind index funds is that over the long term, no fund manager can pick stocks and beat the market. Most research shows that while some active funds can beat the market indexes over 10-15 years, fund managers can almost never beat the market for the long term of 15 years or more.
Index funds also tend to cost far less than actively managed funds.
Types of Index Funds
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Index funds exist that track stock and bond indexes. Index funds track the broad market, such as a total stock market index, or large capitalization stocks, such as the S&P 500; or international stocks, such as the Financial Times 100.
The bond market is also tracked by several indexes, and index funds exist that track these markets.
Considerations
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While few actively managed funds can beat the market averages over the long term, many can perform very well for as long as a decade.
Index funds can experience severe drops during market corrections, while active fund managers can often limit losses by investing in cash or cash equivalents during market downturns.
Index funds offer simplicity and low cost to investors
Carefully research any fund you invest in and decide whether you prefer index funds or active fund management.
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References
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