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Mutual Funds

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The vast majority of mutual funds are actively managed, hence the name Active Funds. Active funds have a full scale management team that set the fund’s objectives. They track, research, purchase, and sell investments fitting within the fund’s prospectus. Instead of having to make independent decisions you simply allow active fund managers to operate on your behalf. You can choose the style of the Active Fund based on the prospectus and stated investment objectives, but you will not be able to have any input on investments held within the fund. You surrender the right to select investments by investing in an active fund. If selecting an active fund, be sure to read the prospectus, annual financial statement, and statement of additional information. You can decide if their strategy is correct from the information contained within these documents.

Active Funds Versus Index Funds: Costs

Active funds have higher costs than index funds. They require research and tracking, while index funds simply match an existing index. Active funds must purchase research, set up news feeds, purchase price tracking systems, and pay traveling expenses to review the investment quality. They pay researchers and analysts to check and recommend investments. Active funds also pay trading fees far more often, since index funds simply hold a portfolio. Those expenses stack over the long term, resulting in active funds being far more expensive to operate than index funds. Active funds face a performance hurdle due to these fees, since costs reduce returns. To beat the market, actively managed funds must create performance that equals cost to break even, and then exceed the market returns. This is unlikely, which is why so many lag behind their indexes.

Index funds excel at low costs and fees. Over the long term, that alone is enough to defeat the vast majority of actively managed funds. Index funds do not have to constantly research, travel to investigate potential investments, or make use of analysts and researchers. They also do not have to constantly trade shares, incurring trading commissions. Low turnover equates to low amounts of trading expenses. They simply create the index portfolio and hold it. They only make minor adjustments to the overall index fund. They save money on all of these costs. Since they have lower overall expenses, they also charge less in fees and commissions. They can charge substantially less than active funds, ranging from 25% to 50% less in fees. This reduced expense means you keep more of your fund’s returns, which increases the chances your index fund will exceed your active funds in returns.

Lastly, both Index funds and Active funds exist with specializations. Some funds will invest in growth shares only, others in value shares. You can find specializations for both funds in specific markets, industries, or nations. Both equity and bond markets can be indexed.

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