You ask, we Explain!
This week we are launching a new segment called "You Asked for It" where we will be answering questions we are receiving through our Facebook page or from current clients that we feel are likely to be shared by many of our followers. We hope to keep our answers concise yet thorough and explained in a manner that simplifies what can be very complex topics.
This weeks questions comes from an existing client who for compliance purposes we cannot name! We will call him Mr. G, who writes:
I see a lot of commercials talking about low-cost index funds. Why is an index fund different than any other mutual fund and why are they lower cost?
This is an awesome question and one we cover a lot with current and prospective clients. Let’s start with the what, and then finish with the why.
An index fund is a mutual fund that is constructed to match a given stock market index. For instance, many mutual fund companies have an S&P 500 Index Fund which will mirror very closely the performance of the overall index. There is no fund manager actively buying or selling stocks within this portfolio. The only time a change would be made to the holdings of an S&P 500 Index fund would be if a new companies stock was added or dropped from the S&P 500 index. For just about any Index, you’ll find replica Index Funds created by investment firms to mirror that index. There are small cap indexes, international indexes, and even sector specific indexes that can be replicated by Index funds.
On the flipside, an actively managed mutual fund will operate based on an investment objective, but is not meant to perfectly replicate a given index. The actively managed fund is not likely to mirror the S&P 500 identically like an Index Fund would. The actively managed fund has a portfolio manager or managers along with a team of analysts who are continuously evaluating the portfolio and making decisions on how to allocate the funds assets. The manager of an actively managed fund has more freedom to concentrate the funds assets into certain companies he or she feels have the best long-term growth prospects while avoiding stocks of companies he or she is not as confident in. The idea here is that a good active manager with a solid team of analysts may be able to outperform the indexes over long periods of time, therefore delivering better than expected returns to the shareholders of the fund. Of course, there is also the risk of underperformance. An actively managed fund may be overly invested into companies that return less than the overall index over a period of time.
As to the why – that is, why are index funds marketed as lower cost? It’s simply a question of man-power. As stated above, an actively managed fund has a manager or managers who oversee a team of analysts who are working to try to deliver long-term returns for the shareholders of the fund. These folks all have to get compensated for their time. This usually results in a higher expense ratio for the fund. On the other hand, with an index fund, because the portfolio is built to simply track an index, there is not much management that goes into it. Index funds are kind of a “set it and forget it strategy” which requires a lot less man power and therefore less expense.
Which type of fund is better? That’s a seemingly never-ending debate. Looking back through the decades, there have been periods of time where active has outperformed passive and other periods where passive has outperformed active. While passive funds have the built in advantage of lower costs, active has the advantage of strategic allocation. When an active manager feels the market may be nearing the end of a cycle, that manager may have the flexibility to allocate the fund in a more defensive manner and even raise cash in the fund. When a market falls, the active manager may have the flexibility to purchase stocks at a discount, turning a bear market into a potential long-term growth opportunity for the shareholders.
There’s no definitive answer to which strategy is best and each advisor has their own philosophy. For us, we feel it’s important to look at active vs. passive the same way we look at portfolios overall. Diversification is key. Owning a mix of both active and passive ensures you’re always participating in the better of the two strategies at any given time.
We hope this helps provide some clarity! This really just scratches the surface on index funds and active funds, so if you want to learn more, ask your current advisor or reach out to us and we’d be happy to take a deeper dive with you.
Investing in mutual funds involves risk, including possible loss of principal. Fund value will fluctuate with market conditions and it may not achieve its investment objective.
There is no guarantee that a diversified portfolio will enhance overall returns or outperform a non-diversified portfolio. Diversification does not protect against market risk.