Index funds, mutual funds, exchange-traded funds (ETFs). Actively managed funds versus passive management. What do all these terms mean? Here’s a breakdown for investors.
Index funds and mutual funds differ in terms of costs and other key structural factors
The epic battle of Wall Street—bulls duking it out with bears—has long included a spirited undercard: passively managed index funds versus actively managed mutual funds. Are investors better off trying to match the broader market “pound for pound” using an index fund that tracks the S&P 500 or another benchmark? Or does a “heavyweight” investing strategy require active, professional management to punch above your weight?
Among market professionals, index-versus-active “has been a contentious subject for decades,” S&P Dow Jones Indices LLC researchers wrote in a 2018 report. “There are few strong believers on both sides, with the vast majority of market participants falling somewhere in between.”
Index funds versus mutual funds, active versus passive: what’s the best choice for investors? For starters, there are structural differences between index funds and mutual funds that are important to understand, according to Viraj Desai, senior manager, portfolio construction at TD Ameritrade Investment Management, LLC. Here are a few basics for investors.
Aimed at offering broad market exposure, an index fund is constructed to track a certain market benchmark, such as the S&P 500. Although an index fund can be considered a form of mutual fund, an index fund is a “hands-off” sort of vehicle that doesn’t try to beat the market. Instead, it tries to reflect the market. For example, if the S&P 500 rises or falls 1% in one day, an index fund emulating the S&P 500 will, in theory, rise or fall by the same percentage.
“Index funds typically have lower management fees because they are passively managed,” Desai said. “That is, rather than trying to beat a benchmark’s performance they’re merely trying to replicate the benchmark performance.”
A mutual fund is a professionally managed financial security that combines assets from multiple investors in order to purchase stocks, bonds, or other securities. If you buy shares of a mutual fund, you’re throwing your money into a pool along with other investors in the fund.
In contrast to the “copycat” approach of index funds, a mutual fund manager tries to do better than the S&P 500 or another benchmark. For example, an actively managed mutual fund may include certain stocks in the S&P 500, but the fund manager will probably also buy other stocks or assets in hopes of constructing a portfolio that outperforms the S&P 500.
If the S&P 500 rises or falls 1% one day, the actively managed mutual fund may rise or fall by a greater amount, depending on the composition of the portfolio. The performance of an actively managed fund likely won’t be identical to the S&P 500.
Actively managed mutual funds “can be significantly more expensive,” Desai said. “You’re paying for the talents of the portfolio manager and for the potential to outperform the broader market.” That’s one important reason to understand fund expense ratios.
Active or passive, index or otherwise, the universe of funds is vast: more than 13,000 mutual funds are available through TD Ameritrade.
As the bull market in U.S. stocks rolled on, few professional money managers kept pace with the broader market. As of mid-2018, 78.5% of large-cap funds underperformed the S&P 500 over the previous five years, according to S&P Dow Jones Indices (which publishes the S&P 500 and other indices). Over the past 10 years, 88% of large-cap funds underperformed the S&P 500.
“There was a time when equity active managers did quite well,” Desai pointed out. But in the current cycle, some factors may have led to active managers’ underperformance, including portfolio strategies that caused some to shy away from higher-valuation shares, such as those of technology companies.
Active managers “not fully participating in the upside offered by the tech sector during this cycle is one contributing factor to underperformance,” Desai explained. “Technology shares have been trading at high valuations for a few years, making it hard for managers to justify buying those stocks.”
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If you’re looking for something economical in terms of fund expenses, an index fund may be a good choice. The typically-low expense ratios can help you achieve your long-term goals with broad index exposure at minimal administrative cost. Also, the S&P 500 is a highly efficient index, according to Desai. “As U.S. equity markets became more electronically traded, with information now processed much faster, it’s much more difficult for an active portfolio manager to tease out unique views that could help them beat the index.”
With an index fund, investors will likely find the efficiency of the market useful for replication, while active managers may have less of an advantage.
The U.S. bull market is now in its second decade. But nothing is forever, and market dynamics may eventually shift from a “rising tide lifts all boats” environment to more of a stockpicker’s market, requiring more discretion and selectivity and the sort of critical thinking that only humans can provide.
Investors looking for more complex and nuanced portfolio strategies might consider actively managed mutual funds. But first, do your homework.
When considering actively managed mutual funds, “ask whether the universe of stocks the fund invests in is broad enough to be conducive to outperformance,” Desai suggested. Also, investors should understand the asset management process and get familiar with the managers themselves.
“Who is making the day-to-day decisions—are they qualified? Are they experienced?” Desai asked, referring to fund managers. “What is the ‘alpha’ [performance relative to benchmarks] that they believe they can extract from their respective market?”
Investors should read a mutual fund’s prospectus to get a sense of the kinds of investments the fund managers make. “Are you comfortable with that exposure?” Desai asked.
Desai recommended a “five Ps” approach to selecting mutual funds:
Exchange-traded funds (ETFs) offer another choice for investors seeking diversification and can be compared alongside mutual funds.
Both ETFs and mutual funds represent a professionally managed “basket” of securities, typically stocks and bonds, but they’re structured differently. Most, but not all, ETFs feature a passive management approach, which is similar to index funds and in contrast to actively managed mutual funds. As with any type of fund, expense ratios for ETFs vary, and it’s important to understand other features of ETFs and how these instruments work.
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