Chapter 2-2 Active or Passive Funds

An actively managed mutual fund hires a professional portfolio manager, or group of managers, to determine which intrinsic investments to select for its portfolio.  One basis for selecting a particular fund is to take advantage of the knowledge of its professional managers.  A profitable fund manager has the background, the expertise, and the time to find and follow investments.  These are important characteristics that you may not have.

The purpose of an active fund manager is to outperform the market, which means to get more profitable returns by picking investments that he or she consider to be the best performing choices.  There are a variety of methods to calculate market performance.  However, every fund is measured against the relevant market index, or benchmark, based on its established investment approach and the kinds of investments it executes.  For example, many large-cap stock funds generally utilize the Standard & Poor’s 500 Index as the benchmark for which they are measured against.  A fund that invests in stocks across market capitalizations might utilize the Dow Jones Wilshire 5,000 Total Stock Market Index, which in spite of its name measures more than 5,000 stocks.  Included in these 5,000 stocks are small-cap, mid-cap, and large-cap stocks.  Additional indexes that follow only stocks issued by companies of a particular size, or that track stocks in a specific industry, are the benchmarks for mutual funds investing in those sectors of the market.  Likewise, bond funds measure their performance against a benchmark, like the yield from the 10-year Treasury bond, or against an extensive bond index that follows the yields of various bonds.

One of the difficulties that portfolio managers confront in accumulating better than standard returns is that their funds’ performance has to offset for their managing expenses.  The returns of actively managed funds are lowered first by the cost of appointing a professional fund manager and second by the cost of purchasing and selling investments in the fund.

Nearly all actively managed funds do not outperform the market in any year.  Research demonstrates that hardly any actively managed funds accumulate better than standard returns over extended intervals of time, counting those with notable short term performance returns.  This is why a lot of people invest in funds that do not try to outperform the market at all.  These funds are called passively managed funds, also referred to as index funds.

Passive funds look to match the performance of their benchmarks rather than beating them.  As an example, the manager of an index fund that follows the performance of the S&P 500 generally purchases a portfolio that contains every stock in that particular index and in the same percentage as they are realized in the index.  If the S&P 500 were to delist a company, the fund would sell it, and if the S&P 500 were to add a company, the fund would purchase it.  Due to the fact that index funds do not need to hold on to active professional managers, and because their assets are not traded as often, they usually have reduced managing expenses than actively managed funds.  But the fees differ from index fund to index fund, which signifies that the return on these funds differ as well.

Some index funds, which are known by names like enhanced index funds, are hybrids.  Their managers are very careful or particular in selecting among the investments followed by the benchmark index with the purpose of offering a greater return.  In years that are bad, this hybrid strategy may generate positive returns, or returns that are a little better than the total index.  It is also always likely that this kind of hybrid fund will not perform as well as the total index.  Furthermore, the fees for these enhanced funds may also be more than the typical for index funds.