One of the perils of working in financial planning is that you speak in this weird language that you think others understand, but they don’t. This is where I rely on my friends to let me know when I am writing in financial-babble.
So, this blog goes out to my good, honest friend Dana Lynch. Thank you, Dana, for telling me that my index fund vs actively managed fund blog was still confusing. Since Dana is a wardrobe consultant extraordinaire (visit http://elementsofimage.com/), I will re-frame this discussion in terms of a closet. We’ll see if that helps.
Think of your portfolio as your closet. In your closet, you have different categories of clothes. You have dress clothes for work, casual clothes for general running around, and spandex/ratty clothes for the gym. In the same way, think of your investment portfolio as your closet. It contains different categories of investments such as US stock funds, Bond funds, and International funds. With me so far?
OK, now to get to index vs. actively managed. In your closet, you have clothes that come together as a matching set (like a business suit) and clothes that you buy as separates (skirts, pants, shirts, belts). A business suit is easily put together and it will always look average-to-OK. You don’t have to search all over the mall to get all of the pieces to create the outfit, so the time and cost of a business suit is usually lower than creating your own unique outfit.
This is similar to an index mutual fund. Index funds are based on a pre-created list and all the mutual fund manager has to do is buy the stocks or bonds on that list. It takes little energy or time and so the cost of creating and managing that fund is low. The results will always be average-to-OK (the fund will return whatever the list returned, no more or less).
You might be the type who is always out looking for original pieces to create ensembles that will make you stand out from the crowd. This would be an actively managed wardrobe. It could look fantastic (Blake Lively), or it could be a total disaster (Helena Bonham Carter). Either way, you’re not following a style formula, you are creating something unique. This takes more time, energy, and money to create than a matching business suit or sweat suit for the gym.
The same is true with actively managed mutual funds. The manager is creating his own unique blend of investments and trying to beat the established pre-created lists. Some years, he will far out perform the standard investment list. Other years, he will do worse. All of this research, creativity, and trading in the portfolio costs more money than the index fund investments that just follow the list.
I hope this analogy helps clarify the difference between actively managed and index funds. If not, let me know. I can probably come up with a comparison to food or sports.
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