Index Funds vs Actively Managed Funds: what are the main differences?
There are significant differences when it comes to Index Funds and Actively Managed Funds. Deciding between the two will depend on various factors including your risk appetite, the ROI you are looking to achieve and the timeframe in which you are looking to achieve this. When weighing up these factors it’s useful to know what each type of fund entails, what the main strengths are as well as some of the potential drawbacks of investing in them.
An index fund (also known as a Tracker Fund) is based on a particular market index and aims to track that specific index as closely as possible. The most recognized of these indices are possibly Standard & Poor’s 500 Index, consisting of 500 of the largest US companies that’s listed on the NYSE.
An index fund can be structured in different ways, including a unit investment trust, an ETF (exchange-traded fund) and a mutual fund. It doesn’t rely on a management team to make the investment decisions. Instead it’s managed passively as each fund has an overseeing portfolio manager, mirroring the index and not actually trading securities on the basis of knowledge about the financial markets.
One of the benefits of an index fund is that it is less complicated to understand and provides a much safer investment avenue. As such it is used by large corporate investors and novice individuals alike, as performance are less volatile over a longer period of time.
Additionally, index funds also tend to have lower expense ratios and, in many instances, offer more tax savings. Coupled by the fact that it doesn’t rely on stock selection by an individual, many of the market risks are eliminated.
One of the drawbacks of investing in an index fund is the absence of flexibility on offer. This is because in this type of fund there are more precise guidelines and strategies that have to be followed in order to match the specific index. Investment decisions must be executed with index returns in mind.
Another disadvantage is that investors are less likely to enjoy big gains in relation to the amount that they invest. It can’t outperform the market that it’s invested in; it can only grow in line with it. Unfortunately this means that when you do invest in an index fund, you abandon the chances of vast gains.
Actively Managed Funds
An actively manage fund will generally have an individual manager or team of managers that’s actively involved in making investment decisions for the fund. Unlike in an index fund, the success of the fund relies heavily on the fund manager’s knowledge, expertise and research of the market. So the manager will complete detailed analysis of various investments in a bid to exceed a specific market index.
One of the main advantages over an index fund is the flexibility in decision making. Investments are made based on the performance of individual companies (which is a powerful indicator) rather than the performance of a whole group of entities that make up an index. There are many instances of actively managed funds out-performing wide market indices on a consistent basis.
You will have an expert team monitoring and adapting your investment as time goes by. They will buy and sell certain stocks and securities depending on performance. This is an extremely valuable factor when it comes to volatile markets. Additionally it means that returns could potentially be much higher than that which is achievable in index funds.
However, considering that the goal of a fund manager in an actively managed fund is to beat the overall market, more risks do come into to play. After all higher returns go hand in hand with higher risks.
With added risk comes the issue of trust. Can you trust the manager in charge of your investment to have your best interest at heart? Will they make informed decisions based on expert knowledge? Many critics will argue that’s it more a question of luck than skill and knowledge. To mitigate this trust deficit, many people will look to the most reputable organisations active in the market. However, in most cases, this will mean higher fees.
The costs of actively managed funds are greater than those of index funds. The reason is because the individual and expert advice that’s enjoyed in specific security related investments comes at a cost. Investing firms have to pay investing managers to look after individual investments.
In conclusion there is no right or wrong. The “correct” type of fund will depend largely on individual investment needs, risk appetite and investment goals.