Tag Archives: index

Does Active Management Have a Place in the Modern Investment Portfolio?

As index funds have become more and more popular a rising question has been, does active management still make sense for the average investor? Answer is of course not simple enough for a yes or no answer. However there are a few pros and cons we can look at for the two options. First let’s look at the advantages of passive management:

1) Relative autonomy 

Time is often saved from having passive investments. While of course there is initial research that goes into selecting the underlying ETF’s or mutual funds, once set up your strategy you will have relatively low time costs going forward.

2) Lower expenses

With passive management comes low expenses. Over the long term expenses can eat into  a large portion of your returns so paying close attention to this is crucial.

3) Lower taxes

Active management usually means less trading and less trading means both less transaction costs and less capital gains tax. Both of these add up in the long term.

Now that we’ve covered a few of the pros of passive management let’s dive into some of the pros of the alternative…

1) Potential for greater returns

By definition a passive manager can’t meaningfully beat their respective benchmark. However with active management everything changes. There is also ways a chance for outperformance. Of course the flip side of this double-edged sword is that you can underperform, which is often the case.

2) Lower volatility

Depending on the management style you are able to experience lower volatility in your investments from active management.

So which should you choose? After everything is said and done the thing that matters the most is your returns relative to the corresponding benchmark index. For example if you’re comparing a large-cap active fund verses and S&P 500 index fund.

Once you’ve selected your funds for comparison you need to determine if a) your fund has outperformed the benchmark in the past enough to cover expenses and additional active costs and b) will the fund continue to perform this way or better in the future.

If you can answer yes for both of these questions you may have a great candidate for an active portion of your portfolio.

The last option you have available is to execute the active management your self. This is a whole different story that deserves it’s own separate discussion for a different post. For the time being focus on comparing returns both pasts and potential for the future.

Active Mutual Funds Vs Index Funds: Which is Better?

Mutual Funds

A mutual fund is basically an amount of money that is “mutually funded” by a large amount of people. This money is managed by fund managers who require a percentage fee for their labor. The managers invest in securities and as the value of the investments rise or fall, so the equity of the shareholders in the fund rise and fall.

So if you purchased one $1 share of a $100 fund then you own 1% of the overall value of the fund. If the management’s investments of the fund raise the value to $110 then you just made 10% and your share is now worth $1.10.

This is a very simple overview. Clearly the details are much more complex. For example the management fees, taxes and dividends change the return dynamic. But in terms of understanding the basics of mutuals funds, this does the job.

1. Active Mutual Funds

An active mutual fund is one in which the manger(s) work to select the best security investments they think will produce the best returns. They usually charge a higher management fee because of the perceived value and expertise they provide.

2. Index Funds

The alternative is to have a fund set up in a way that involves very little research and work on the part of the management. “But why wouldn’t you want to take of advantage of the manager’s expertise?” you might ask. The answer comes down to two variables: Cost and performance.

Not only do active mangers usually charge higher fees (cost) but they often don’t actually invest in a way that outperforms the market(performance). So the alternative that involves lower cost is called “index investing”.

An index is essentially a set of stocks that meet certain requirements or have certain common characteristics to one another. For example the most popular index, the Standard and Poor’s 500. It’s an index that takes the 500 largest US stocks on the market.

What this means for index investing is that an S&P 500 Index Fund would be managed in a way to match the S&P 500 index. In other words, the mangers would simply try to buy and sell stocks to keep their investments in line with the 500 largest companies on the market. That’s how they can keep their management fees so low – they don’t have a ton of research to do.

Index Options

But there are other indices. S&P 500 is the most popular but there are others like the Dow Jones Industrial Average (DJIA), which is 30 massive companies weighted according to price. The DJIA is the oldest index.

The following are some others that you might like to consider:

The Nasdaq Composite Index

The Nasdaq is actually a stock exchange that predominantly trades technology companies. The index seeks to perform according to the stocks on the exchange.

The Russell 2000

Of the 3000 largest companies in the Russell 3000 (another index), the Russell trades the bottom 2000. Thus, this fund trades mostly smaller to middle size companies.

There are many, many more you can look up on your own. The bottom line is that for most cases index funds provide the better choice.

Different Stock Investing Strategies

I am going to briefly cover the top most widely used “investment” strategies for stocks. Technically not all of these methods are investing because a few of them involve short term trading.

1. Stock Index Mutual Funds

There are many types of indexes. Indexes are essentially a predetermined basket of stocks that are formulated using a set of rules. For example the most widely used index, the S&P 500, is an index that incorporates the 500 largest companies in the US and weighs them in the index accordingly. There are other indexes such as small-cap indexes or tech stock indexes. The bottom line is that with an index you are purchasing a tiny portion of a large basket of US stocks that is going to reflect your sector of choice.

2. Actively Managed Mutual Funds

Actively managed indexed funds are very similar to indexes except for 1 key difference: They aren’t bound by a predetermined set of guidelines. For example an active mutual fund might have a focus on large-cap stocks or international stocks, yet there aren’t any rules on how much of each of these have to be purchased. This is different from an index where the predetermined weight of each stock is set in stone. Out of this difference comes an increase in management fees because of the funds active, and therefore more costly management structure.

3. Value Investing

This is the method used by the smartest and most successful investors (in my opinion). Warren Buffet is the most famous example of this. Value investing involves determining a company’s value (regardless of current perceived value) by looking at a balance sheet and income statements using fundamental analysis. As the investor sees a price drop well below it’s determined real value the value investor can seize up good deals and hold on for the long-term.

4. Day Trading

This is a common strategy by short-term investors who use primarily technical analysis (looking at charts and trends) to make “investing” decisions about which stocks to buy and then sell quickly for a profit. The risky thing about this is that if you accidentally buy a stock or ETF that suddenly drops in price, you could get stuck with a plummeting investment that was truly overvalued.

5. Random Strategy

This strategy is specifically for people who don’t know what they’re doing and don’t even pretend to try to act like it. They randomly purchase stocks that “sound cool” and then hope that they rise in price. By far this is the stupidest strategy just behind day trading. You can lose your shirt much easier with mindless/random investing or day trading than you can with the other strategies I outlined above.

Conclusion:

Whatever you do, please don’t choose route 5, and preferably strategy 4 as well. Not only is day trading risky and the fees expensive, it has also be statistically been proven to outperform traditional investing methods over the long-term.