Investing 101 — Managed Funds vs. Index Funds

by Jamie Dlugosch | March 14, 2012 11:00 am

Individual investors have many options to choose from when deploying dollars in the market. Mutual funds are desirable because they allow smaller investors the ability to pool assets with other investors. This larger pool enables greater diversification, which generally is thought to be an important pillar of successful investing.

Within mutual funds, investors must make a choice between a managed fund — a fund that is actively managed by a professional — and an index fund — a fund that is passively managed using an underlying index to guide decisions. There are merits to both styles.

Managed funds offer the opportunity to make more money than an index fund. That simple but alluring benefit is why so many managed funds exist today. Even though most managers underperform the indices, the few that consistently beat make it all the more worthwhile to pursue such a strategy.

One of the benefits of choosing an index fund is expense. Managed funds typically have higher expense ratios. It takes big bucks to pay a top performing manager and his or her team of analysts. That expense is all but eliminated with an index fund, as you’re merely buying stocks of a particular index. The biggest challenge of the index manager is properly weighting holdings so as to reflect the actual index. Beyond that, there is not much thought involved.

Ultimately, the biggest benefit of an index fund is peace of mind. There is no sense worrying about the gyrations of the market. The index will do what it will do. And, historically, index funds deliver a rate of return that, over the long haul, is better than most investment alternatives available to the individual investor.

That peace of mind comes with a price. If the market does goes down, it is all but impossible for an index fund not to lose money. With an actively managed fund, the professional manager can move in and out of the market or a particular stock if he or she so chooses. That means in a down market, the managed fund is likely to greatly outperform the index fund.

So, both managed funds and index funds have their benefits — the individual investor should choose based on preference and acceptable risk.

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