Yahoo! - Active Management and Indexing

Topic - Active Management and Indexing

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You can build a portfolio using actively managed funds or index funds -- or both -- but 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.

The indexing rationale
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, as shown in the chart below? The answer is low costs. 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.

The Indexing Advantage
Ten years ended December 31, 2001		Cumulative Rate	Annual Rate
Average general equity fund		199.2%	11.6%
Annual rate Index fund with average costs*		209.7%	12.0%
Very low-cost index fund**		218.3%	12.3%

Source: Lipper Inc.
*	The returns of the Wilshire 5000 Index have been reduced by 0.82% per year to reflect the expense ratio of the average index mutual fund.
**	The returns of the Wilshire 5000 Index have been reduced by 0.20% to reflect the expense ratio of a very low-cost index mutual fund.

The information shown is hypothetical. It does not represent returns from any particular investment.

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.