So you have money to invest and you want to be in stocks and bonds. You've decided you'd rather go with the diversity of a fund but now what? Do you go with a fund managed by an individual or a board of directors with stock picking expertise? Do you just follow the overall market with an index fund?
The main distinction between a managed and an index fund is that the index simply mimics a portion of the stock market (depending on which index fund chosen); whereas, a managed fund relies on a manager or group of managers to choose the stocks in the fund and decide when to buy or sell to maximize returns and offset losses.
Obviously, the managed fund initially sounds better. Who doesn't want someone with experience to improve their return and protect them from losses? One would think with the complexity of the investing world that a knowledgeable expert would be the best choice. However, some pitfalls exist with managed funds.
First, the fees with most managed funds, aka active investing, are higher than an index fund, aka passive investing. At first glance this would seem reasonable in that you would be paying for the fund manager's expertise. However, to justify these higher costs a fund must consistently beat the market and by extension beat the index. Most don't. In fact, 60-65% of managed funds lose out to index funds over a five year time frame. So the odds of buying a fund that continues to beat the market are daunting. Add to that the fact that the fund then has to beat the market even more to overcome their higher fees and it becomes apparent that indexing offers more advantages.
Second, if these active managers are so expert in their field then why do their funds lose money when the rest of the market plunges? Shouldn't they have been wiser than the average investor? After all, they had all the information on the companies in the fund that an average investor lacks.
A third disadvantage with active funds is that they do trade more frequently. Because of this active trading there is more portfolio turnover meaning buying and selling stocks more frequently. This translates into more taxes for the investor since each time a stock is sold a capital gain or loss occurs. Perhaps more taxes would be acceptable if the frequent trading resulted in market beating returns. This often doesn't happen.
So, what about index funds? The advantages of index funds are low cost (less fees) and higher odds of earning what the market returns. The fund simply buys all the stocks in the index that it tracks. There is no management team or board so there is no one to whom a salary is paid. Therefore costs are kept low. Just a note, never buy into a load fund. You will be told this is because you are paying for the fund's expertise. Don't believe it. There are plenty of no-load funds that do an excellent job at a low cost. Especially do not buy an index fund with a load. There is no special expertise involved in tracking an index. Index funds only buy or sell a stock when their underlying index changes. Therefore, there is very low portfolio turnover and subsequently less taxes.
All of this translates into a fund that equals a market return minus a small expense. Although this may not sound like the best return you can get, especially when hit with a bear market, the fact is that most active funds won't even return the market equivalent and then subtract even higher fees. Add in the higher taxes from portfolio turnover and you pay a lot for an active fund's expertise.
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