Introduction
This paper contains a comparison of the actively managed funds and the index funds. To begin with, the actively managed fund is the liquidity pool which has a portfolio that is used as a platform of a trade by investors to meet their long-term objectives in an investment. On the other hand, the index fund is defined as the fund, which helps to keep records that march the performance of different markets in a certain period. For a long period, investors have been debating on the best form of investment and they have found that actively managed funds are the future of investments. In fact, active management is the best form of investment due to the reduced number of risks in the business. Inactive management, one is able to put their wealth in hedge funds, has returns, which are superior and reduced involvement in the management of the funds. On the other hand, investing in index funds is not lucrative due to the increased involvement, fewer returns and the huge risks involved. To sum up, the future of investment lies squarely on the active management of funds.
Index Funds Definition and History
An index fund can be defined as a mutual fund that keeps records of stocks, which match the market performance. It is often termed as the market fund and the selected funds are one of the parameters, which are contained by the index. The long-term benefit of the index fund is to measure the stock index like the S & P 500 index. The main objectives of the fund are to minimize the costs. The portfolio of stocks is constructed using the index fund as the index, which has been chosen. Index funds often reduce the purpose of an individual to work and extra mile and worry about their cash. Depending on the performance of the overall selected market, index funds help to give people assurance of increased performance (Ferri 222).
The history of index funds dates back to 1951 when John Bogle a Princeton University student wrote a thesis on mutual funds. It was assumed that when the mutual funds were managed in an efficient fund they would help an investor to earn more from the investment. A low-cost fund was thus created thus reflecting the index of the market. Index funds were thus created for the investors who dealt with retails to form the largest market fund in the world. The creation of the index fund began in the United States of America and then was adapted to the rest of the world over the years. In 1990, the United States created the biggest share of index funds in the world through the aid of Vanguard a professor at Princeton University (Boggle 123).
Index Fund Market Performers
Index Fund Market performers often demonstrate the performance of active funds over a long period. The index funds unlike the ETFS often help the investors by exposing them to the market. In order to test the performance of the index funds, it is important to focus on the MSCI index to know how the fund has performed in the market. Although the Equity fund is used to tell the performance of the index funds, it is usually affected by economic factors such as high inflationary levels. Performance deciles are also used to tell how an index fund has been performing over a long period. Investors also tell the performance of an index fund through its increase in the percentages or the decrease in the percentage over time. Index funds are also used to test the general performance of the emerging markets in the economy (Fabozzi 243).
Actively Managed Funds Definition and History
An actively managed fund can be defined as the liquidity pool which has a portfolio that is used as a platform of a trade by investors to meet their long-term objectives in an investment. For instance, a fund that is actively managed can have a return of the targets or a level of target in a risk. In the cases when the targets or the set goals have not been met, the company, which is making the trade, increases its investments in order to rectify the situation. One of the actively managed funds is mutual funds. In order to achieve a certain objective, the investors of actively managed funds often trade investments in order to have a specific level of returns. In this case, actively managed funds are strong than index funds. On the contrary, they have the highest fees of investment and management (Horwitz 133).
The history of actively managed funds shows that the performance of the funds is very high as compared to any other type of fund. In order to increase the actively managed fund, it is advisable to have the reinvestment of the dividends and annual balance of the disposable income and the capital. On the other hand, the management fee of the active fund is very high as compared to any other kind of fund. The same applies to the investment fund, which has a higher cost as compared to other forms of investment. The annual return of the investment shows that there has been an increase in funding for a long period.
Actively Managed Funds Market Performers
Investment portfolio, which is active, managed increases its performance if the managers or the person controlling the investment is skillful and has a good knowledge of the market. Actively managed funds usually are better than index funds due to the simple fact that they are closet indexers that have a portfolio related to the indexes. Inactive management, investors do not have the capability to enforce huge investments but they have an option to increase the returns on the index. In order to perform in active investment, one should be able to exploit the inefficiencies of the market by buying the market stocks. Active management has a low cost due to the low vitality rate characterized by the reduced risk in returns.
According to the Standard and Poor index versus Active (SPIVA), the actively managed funds over a long period have good gains than the Standard and Poor index portfolio. It is also evident that over time, the actively managed funds usually increase their gains. The mutual fees help the actively managed fund to increase because the indexes have no extra costs in the investment. In volatile markets, active management is important because the risks are low and the gains are high because an investor has an option of increasing the investment through the hedge funds (Fabozzi 167).
Characteristics and Management of Index Funds
Operation Principles
Index funds are always intended to track the market index returns such as the bond and stock markets. They hold all securities as the respective index in the same proportion. They are passively managed. The portfolio manager of each individual index fund always attempts to replicate the index. This means that the index defines that the index determines the outcomes of the investment. The analysts may use the index to predict the outcomes of an index fund using the index. He or she does not trade securities according to his or her views on the potential risk and reward of the securities. There are different varieties of index funds. Some of them include all the stocks in the U.S. while others are smaller indices contained in larger ones. Other specialized index funds include foreign currencies and commodities. Index fund shareholders are grouped into several classes such as A, B, C, etc. This helps investors to choose the best class to invest in concerning their options.
Costs
The cost of owning index funds is relatively less than the cost of investing in actively managed funds. Their cost largely depends on the fund company, which is offering the fund, as well as the indices, which the funds track. The fund company dictates the share value. Index funds are also cheaper because the shareholders of the funds do not pay for management fees. This helps to save the huge costs, which are involved in the management of the index fund. Less tax is also charged on the index funds as compared to the actively managed funds and therefore the investors are able to earn more tax savings. Therefore, the investors make huge returns from investing in the index funds due to the reason that there are no extra costs, which are incurred during the investment (Ferri 372).
Risks
In terms of risk, index funds are considered less risky. This is because of a broad index base as compared to specific stocks or sectors. In addition, index funds always tend to outperform most actively managed mutual funds. It is thus easier to predict the performance of an index fund because the index indicators have no risks involved. Another risk of index funds is that it is not practically possible to mirror the exact index. This can eventually lead to a decline in the returns from the investment. In the underperforming indexes, there are many errors involved and it is much difficult to detect them due to the complexities involved. On the other hand, when the market has performed in a good condition, it is also difficult to detect any error thus becoming a big problem to the investors.
Performance and Yields
Index funds do not outperform the index and therefore their returns are sometimes lower. This is because they are meant to match the indices and therefore do not need to beat the market index. This can therefore translate into lower returns as compared to actively managed funds. Sometimes the composition target can be changed and this leads to a decline in the investment returns. However, index funds tend to be more stable and therefore many investors still prefer them (Fabozzi 334).
Characteristics and Management of Actively Managed Funds
In order to build the best portfolio, it is good to manage funds actively. The fund managers deal with various strategies and investments that are unique. Some managers chose to use a bottom-up method whereby they first search for individual securities with the best performance. On the other hand, other fund managers prefer to use the opposite approach; that is a top-down approach. They search for trends in the economy and go ahead to choose companies that have to be advantaged by the chosen trends.
Managers with good experience can be able to give long time performance, which of course is not affected by the nature of investment philosophy. A good manager will be in a position to look for the best companies out of a pool. Information about the best managers and the companies can be found in a fund’s annual report and prospectus. Actively managed fund managers intend to derive good investment returns. The produced investment returns are better because they aim at buying and selling individual securities that can very well perform very well in the market. The manager works very hard to beat the market by making use of a stated strategy. This is done by following macroeconomic trends and getting in touch with companies. The manager picks and chooses the best investments by first analyzing a variety of them. In addition to that, balance sheets are reviewed and the same applies to income statements. Finally, the day-to-day activities of a company are closely monitored (Fabozzi 199).
By looking at the number of funds and assets that are being managed, it is clear to say that most of the companies are mutual funds. Mutual funds may either have actively managed portfolios or passively managed portfolios. In actively managed portfolios, a professional investment adviser produces a mixture of investments. This is done in order to achieve an investment objective that has been set. On the other hand, in passively managed portfolios, a particular benchmark or index performance is analyzed. One great similarity between the two is the fact that the securities that are used are all redeemable. That means that the fund is always in a position to buy its shares back and that is done using their current net asset value abbreviated as (NAV). In order to get the NAV of shares, the fund’s liabilities are subtracted from the total market value of the fund’s assets and the number of mutual fund shares that are outstanding divides the result.
The difference between mutual funds and other companies is the fact they are externally managed. They are not operating companies and therefore they do not have employees. They make use of third parties to deal with most of the business activities including asset investments. The funds are supposed to write their own compliance programs that show all their procedures and controls that should comply with the law (Ferri 182).
Operation Principles
In actively managed funds, an individual is put in charge of managing the funds. He is responsible for making investment decisions by conducting research and analysis of many investments and choosing the best option. They can be classified into two categories. One of them is where the investor decides to take up the investment decision personally and takes full control over the funds. The other option is where the investor decides to employ the services of a financial professional. Whatever the case, the manager of the funds is responsible for beating the market in his or her own ways. There is an advantage of an investor making the investments personally. First, he or she is able to decide where to invest without having to consult the services of a professional. There is also the freedom to choose the quantity of investment to make as well as the advantage of saving the returns, which would otherwise be used to pay the professional? It is literally known as a high-risk and high-reward operation. One of its drawbacks is the lack of vast information about the market that large firms have, which can affect the investment decision (Haslem 155).
Costs
The costs of operating an actively managed fund are higher as compared to those associated with operating a passively managed one even if trading is not frequent. This comes with its own good as extra value is derived from making use of actively managed funds. This is because the fund managers are allowed to buy and sell securities after doing thorough research. The buying and selling of the securities also depend on the company knowledge and the industry knowledge that they have. Therefore, the amount of money that the actively managed mutual funds charge is more than the amount that is charged by index funds because the managers add more fees as they try as much as possible to be above index returns. As a result, the professional managers running actively managed mutual funds, therefore, try as much as possible to exceed index returns and as a result, they end up increasing the number of their additional fees. The worse part of it is that the high costs make the actively managed funds underperform in relation to the index.
There are various types of expenses, fees and other costs that are incurred by actively managed mutual fund investors. The portfolio managers of the actively managed funds are in search of extra returns. Therefore, they buy and sell investments more times than in an index fund. This action of the active manager is referred to as turnover and it leads to capital gains to the fund shareholders, which are taxable so long as the ownership of the fund is based on a non-retirement account. The costs of running a fund are referred to as the expense ratio and this is very different from the costs of buying a fund. The expense ratio shows the percentage of the fund assets that are used in the expense of running the fund. It includes the entire investment advisory fee, the administrative costs, and the 12b-1 distribution fees, among other expenses that are incurred in the course of the operations (Fabozzi 168).
The investment advisory fee is also referred to as the management fee. This is the amount of money that is paid to the manager and it ensures that they are well dressed every time and they take good vacations to relax their minds. The average management fee is about 0.50% to 1.0% of the fund’s assets each year. The administrative costs refer to the costs incurred because of keeping records, sending and receiving mails and maintaining customer service lines. These necessary costs vary depending on the fund. Most funds can be able to keep this kind of cost below 0.20% of the fund assets annually. The funds that use sophisticated materials like colorful graphics will incur higher costs, which may go high above 0.40% of fund assets annually. The 12b-1 distribution fee is the money used for marketing, distribution of services and advertising. It ranges from 0.25% to 1.0% of the fund’s assets annually (Ferri 167).
Actively managed funds are relatively more expensive than index funds. Statistics show that actively managed funds are 1% more expensive as compared to index funds. This can be attributed to the fact managers of active funds buys and sells investments more frequently compared to index funds. This is always in an attempt to increase returns. This in turn results in taxable capital gains, which are in turn taxed by. When the services of a professional are employed, the cost of managing the funds also increases. This is because of the returns, which are used to pay the salary of the professional.
Risks
In actively managed funds, the manager has more freedom in determining the volatility of the investment. They can choose to make investments, which are riskier in anticipation of the higher returns. On the other hand, the manager can also decide to make the investment in an activity, which poses less risk, but gives more assurance of the returns. Good information knowledge of the market can greatly reduce the risk in the investment. Since the selection of the investment is dependent on the manager, the risk in the investment also depends on him or her. Actively managed funds can therefore be too risky, moderately risky, or less risky.
When making an investment, one is normally aware of the risks involved. Circumstances can lead to a loss instead of a profit and therefore, it is very important to be very careful. The skills of the manager and the research staff greatly determine the effectiveness of an actively managed investment portfolio. Sometimes there could be prolonged market declines. Because of the fund fees, there is a risk of an actively managed mutual fund underperforming in comparison with the benchmark index. The need for actively managed funds still prevails because most of the investors are not satisfied with a benchmark.
There is a risk of the fund manager making bad investment choices. On top of that, there is also a risk of following theories that are not significant in managing the portfolio. There is also a great possibility of incurring low fund returns because of frequent trading which leads to high transaction costs. To make it worse, when funds are held in a taxable account, the capital gains that arise from frequent trades many times have a negative income tax impact.
When the assets are large, the actively managed fund starts becoming like an index one. This is because apart from the fund manager’s chosen investments, it must make more investments. As a result, most of the funds close their funds before getting to this point and that automatically leads to a loss of income in terms of management fees for the fund company. Holding cash in the fund management puts the fund manager at the risk of lagging behind the benchmark. If one lags behind the set benchmark, he/she is said to have experienced the results of career risk. The greater the cash that the transaction involves, the higher the career risk that is associated with managing the fund. There is also a possibility of the fund manager incurring an active risk. This is a risk that is created by a portfolio in its strive to beat the return of the benchmark (Ferri 225).
Performance
As said earlier, the performance of an actively managed investment portfolio largely depends on the manager’s skills and those of the research staff. Different active managers have very different performances depending on the kind of skills they have. Based on a long period, most of the actively managed funds do not outperform the index funds. This is because forty-five percent of all mutual funds have portfolios that look like those of index funds. These funds use the name active funds in order to justify high management fees but in the real sense, they are index funds. Most of the performance of the funds largely depends on the performance of the growth stock index that the funds are benchmarked on.
The performance of the actively managed funds has been very poor compared to that of the index funds. The scorecards of the (SPIVA) which refer to the Standard Poor’s Index Versus Active show that very few actively managed funds have done better than the index benchmark. There is a great decrease in the number of actively managed funds with gains that are better than those of the benchmark are. The percentage of actively managed funds doing according to the expectations of many investors is very small. Therefore, investors may prefer to turn to index funds because they fear taking a risk and end up incurring losses (Haslem 177).
There has been an underperformance of the actively managed funds in comparison to the benchmark index because of the fund fees that have to be met. The securities in the fund perform better than the benchmark since they do not have any expenses to be incurred. Therefore, varieties of investors are not contented with a benchmark return. Therefore, there has been an increased need for actively managed funds. Research shows that by the end of the year 2009, benchmarks outperformed the actively managed funds by one percent each year. With all that, many investors still prefer actively managed funds. This may be because active fund managers have misled most of them since they are not aware of the facts. They are made to believe that, they get what they pay for. This actually means that they have to pay high active management fees in order to get the best results. In most situations, the investors think that they are in a very good position to choose the best active managers and that ends up failing them.
The performance of actively managed funds can be either higher or lower. This depends largely on the type of investment the manager makes. More risky investments always yield more income when the risk does not occur as compared to less risky investments. The decision on the degree of risk to take entirely depends on the manager and therefore the overall performance is dependent on him or her. When they decide to make the lower risky investment, the yield will definitely, also be below. Statistics show that the chances of actively beating the market index are minimal. However, depending on the knowledge of the market by the investor, returns can actually beat the market in several consecutive years (Ferri 224).
Comparative Analysis
In order to manage the actively managed funds, one has to have certain skills and knowledge of investment and the trends of the market. Investors like to invest in them because they have many complexities involved. On the other hand, the index funds are not hard to manage and the investors do not need to have any knowledgeable person to manage them. Secondly, the index funds do not have a high rate of interest because they do not give the investors an option to invest in any other form of funds. Conversely, there are many size advantages, which are involved in the investment of different types of institutions. One is also able to invest in hedge funds and mutual funds, therefore, having a chance of increasing their returns. Corporations are also able to get huge returns for a given period in time (Haslem 144).
Performance and Yields
In terms of the returns that are associated with actively managed funds, there are many superior returns from the investments, which are normally made using actively managed funds. This is because the actively managed funds have a tendency of fighting the market structures and market forces, and therefore they become more powerful in the marketplace. On the other hand, index funds are usually dominated by the forces of the market in such a manner that it is difficult to control the costs of these funds. In index funds, the investors are actively involved in the investment of the funds while on the active investment, the investors do get involved in the management of the investors’ funds.
Professional managers have the ability to research information about the performance of mutual funds. This helps the investors to know the best time to invest their money. It also gives the managers the platform to decide the best time to put their investment into active reserves. The latest information about the performance of the market also gives the investors a chance to show their performance in the marketplace. The edge of information gives the investors the chance to decide when to make their investment a reality. It also improves the performance of the funds in the marketplace (Ferri 177).
Risks
Every business has risks and in actively managed funds, there are risks that are involved. In fact, the manager or the professional who is managing the investment may make bad choices regarding the investments. This may lead to a lack of accumulation of the funds, and it may lead to a huge loss of capital investment. Lack of payment of the huge fees that are normally associated with the transactions may also lead to an alteration of trading patterns, making investment more dynamic and risky. The market may also be unproductive leading to the formation of bad choices in regards to the investment. There is also unfavorable income, which is associated with the short-term investment of the actively managed funds. In order to avoid losses from the short-term investments, investors advise the managers to ensure that they have increased their investments in terms of increasing the cash flow for the returns (Horwitz 166).
In some cases, the mutual companies may close their businesses or even the funds before they reach the maturity period in order to ensure that they have avoided losses which may be because of poor investment. In index funding, there are minimal risks involved although the returns are minimal. It is better to have a few risks in order to prevent the business from having losses. The use of capital gains also prevents the investors from having a mutual investment because the governments may intervene and prevent the investors from making profits out of their capital. Investors should thus concentrate on the reduction of risks if they want to make huge returns and thus reap from their investments (Haslem 78).
Index funds have also their risks, which include the lack of tracking an error from the index. Actually, there are many errors that are involved in the overperformance of a specific index. The same applies when the index underperforms; there are also many errors, which occur during such a venture. The most devastating risk is that in case of losses, there is no way an investor can help to avoid the loss. This is because an index cannot perform higher than the expected target. In addition, the composition of an index also changes the return of the investments. This is because an index can suffer from a market impact more than any other form of investment. Index investment is thus a portfolio that is passive because it mirrors the performance of the indexes. In order to avoid the risks associated with investing in index funds, an investor should ensure that he/she has increased his/her investments in order to reduce the chances of having a failure of his or her investments (Horwitz 223).
Conclusion
In conclusion, active management is the future of investment because it has more advantages than investment in index funds. There are many factors that help to give active investment an edge over investment in the index funds. These factors include the expertise involved. Investing in actively managed funds gives investors time to relax and wait for the increase of their investments without any form of stress. On the other hand, investing in index funds does not give the investors time to relax due to the fact that they have to seek the market information for themselves due to lack of having professional help. Moreover, in actively managed funds, there are more superior returns than index funds. There are no management funds or even investing fees in the index funds. In the same way, index funds normally attract comparatively small returns. Although index funds are considered more liquid than actively managed funds, there are times when the actively managed funds have huge revenue to the investors. To sum up, actively managed funds have an advantage over any other form of funds because they help to generate huge revenues and returns to the investors. This is despite the fact that they are associated with more costs as compared to index funds. That means the actively managed funds are the future of investment.
Works Cited
Boggle, John C. Common Sense on Mutual Funds. New Jersey: John Wiley & Sons, 2010. Internet resource.
Fabozzi, Frank J, and H Markowitz. The Theory and Practice of Investment Management: Asset Allocation, Valuation, Portfolio Construction, and Strategies. New Jersey: John Wiley & Sons, 2011. Internet Resource.
Ferri, Richard A. All About Index Funds: The Easy Way to Get Started. New York: McGraw-Hill, 2007. Print.
Haslem, John A. Mutual Funds: Risk and Performance Analysis for Decision Making. Massachusetts: Blackwell, 2003. Print.
Horwitz, Richard. Hedge Fund Risk Fundamentals: Solving the Risk Management and Transparency Challenge. New York: Bloomberg Press, 2008. Print.
