Happy New Year! In December I veered off in all sorts of random directions with the blog. Between year-end to-dos and general revelry, I got way off task with the decoding financial jargon goal. So, back to work we go.
In past blogs, I’ve explained what a mutual fund is, how to do research picking funds, and how to judge the cost of mutual funds. Now, we turn to the question: What is the difference between index funds and actively managed funds?
Index funds are mutual funds whose investments mirror an already established index meant to represent a certain area of the investment market. One that many are familiar with is the Standard and Poor’s 500 Index, or S&P 500. The S&P 500 tracks the 500 largest US stocks as measured by market capitalization.
So, an index fund that tracks the S&P 500 invests in those same stocks in the same quantities as the list of stocks published by Standard and Poor’s. There is no one thinking about if the investment is good or bad or if the companies will go up or down in value. The fund is mostly managed by a computer program. Since there isn’t a lot of human capital involved, an index fund will typically have a lower expense ratio (see October 23, 2014 blog) than actively managed mutual funds.
In an actively managed fund, a fund manager and his merry band of analysts do lots of research, interviews, and general crystal-ball-gazing and decide which companies to include in their fund. They make proactive decisions on when to buy or sell different investments. They try to beat the overall performance of their particular area of the investment market. For example, the manager of the Metropolitan West Total Return Bond Fund is trying to beat the annual returns of the Barclay’s US Aggregate Bond Index.
Because actively managed funds use people to decide what investments to make (and people like being paid for their work), the annual expense ratios tend to be higher.
This comparison of fees between index funds and actively managed funds is a generalization and not always true! Just because a fund has “index” in the title doesn’t make it cheaper than an actively managed fund. For example, the JP Morgan Equity Index Fund Class C has an expense ratio of 1.42%. The American Century Investments Equity Growth Fund Investor Class (an actively managed fund in the same investment category) has an expense ratio of .67%.
You must always look under the hood of your investments to know the pricing of what you are being sold. Cheaper is not always better, but costs are one of the few things about your investment portfolio that are under your control.
Next time we’ll talk about the big debate: Which is better – active management or index investing?
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