In the world of mutual fund investing, there has been a debate raging on for the past two decades – active management versus indexing. As we describe above, indexing is investing in a mutual fund that tracks the performance of one of the major indexes, such as the Vanguard 500 Index Fund that tracks the S&P 500 Stock Index. Active management is purchasing an actively management mutual fund such as the Fidelity Magellan fund. Although You can build a portfolio using actively managed funds or index funds – or both – you should understand the 2 types of investment strategies before you begin investing.
Managers of actively managed funds seek to produce investment returns that are better than a target market benchmark, such as the Standard & Poor’s 500 Index, by researching and trading individual stocks or bonds. Each manager follows a stated strategy for trying to “beat the market.” Index funds try to track market averages, not to beat them, by buying and holding all, or a large representative sample, of the securities in their target indexes.
Indexing is based on a simple fact: Before expenses are counted, investors as a group earn the market return, whatever that happens to be for any given period. If one investor – through luck or skill – gets an above average return, another is left with a below-average return. Index investors aspire to be average.
Now the paradox: If index funds serve up average returns, why have they been able to beat most actively managed funds that invest in similar securities over the long run. The answer is lower fund management fees. By eliminating the costs of researching stocks and keeping trading costs such as brokerage commissions low, index funds don’t have to take as large a bite out of fund returns. So their average return before expenses has provided the opportunity for above-average return after expenses.
Index funds can also help investors keep their taxes down. Since most index funds buy and hold the securities that make up the index, these funds typically don’t generate as many taxable capital gains as actively managed funds. For this reason, some investors rely on index funds for their taxable accounts and hold actively managed funds in their tax-deferred or tax-exempt accounts.
Some indexes tend to have relatively low turnover of their holdings, but not all indexes offer this benefit. For instance, small-company indexes change as companies grow and become medium-size or large companies. As companies come and go from the indexes, funds that track them must buy and sell to follow suit. A fund’s turnover rate is often disclosed in its prospectus or annual reports.
Vanguard has pioneered this approach to investing. Vanguard provides a broad selection of index mutual funds that enables the MutualFundAlliance.com a broad selection of low-fee index funds such that we can create a series of Model Portfolios that have low expenses, yet enable us to handily out-perform both the indexes and the performance of the average mutual fund.