Mutual funds provide various benefits including diversification, convenience and cost advantage, so it’s no wonder that more than 13 trillion US dollars are invested in them. When deciding which mutual funds to invest in, there are many questions investors must ask themselves, including whether an actively or passively managed fund best matches their investment objectives.
In actively managed funds, a portfolio manager attempts to outperform an index via stock picking, sector weighting and/or market timing.
With passively managed index funds, the manager buys a portfolio of securities that replicate an index such as the S&P 500 or Barclay’s Aggregate Bond Index, or a portion of the market, such as large company stocks or small company stocks.
On the face of it, it seems like active management would be the way to go. Why not just pick the good stocks and forget about the bad ones?
The problem is that it isn’t so easy to do. On average, most actively managed funds trail the index that they try to beat. There are a few managers that do beat their indices over time, but it is as hard to pick a manager that will outperform as it is to pick a stock that will outperform. Managers with good 5 or 10-year track records tend to underperform over the next 5 or 10 years.
The reason that this is so is because the markets are fairly efficient. There are literally millions of investors trying to beat the markets and what happens is that all of those investors trying to buy and sell to gain advantage wind up becoming the markets. As a whole, they tend to underperform.
That is why we recommend investing in passively managed index funds.