One of the most basic distinctions between mutual funds is whether the fund manager employs an active or a passive management approach. An active management style means the fund manager uses analytic or forecasting tools to select individual stocks for the fund portfolio. In a passive approach, the fund manager simply buys whatever stocks are represented by a well-known market index. Funds that attempt to match exactly the day-to-day fluctuations of a market index are known as index funds. Index funds can play an important role in an investor’s portfolio, offering the market’s returns and a known level of risk.
Index Fund Performance
A fund that perfectly tracked the broad Standard & Poor’s Composite Index of 500 stocks (S&P 500) would have posted a gain of of 13.69% in 2014 (less expenses), compared with a 10.65% average gain by all diversified U.S. large-cap equity funds.1 Index funds have generally outperformed many — but not all — actively managed stock funds in recent history. In 8 of the past 10 years, less than half of all large-cap U.S. equity funds managed to beat the S&P 500’s returns. During the five years ended December 31, 2014, the S&P 500 outperformed more than 72% of U.S. large-cap equity funds.2
A Choice of Market Indexes
500 large-cap stocks that make up the components of the U.S. economy
The stocks of 2,000 U.S. small-capitalization companies
Stock markets in Europe, Australasia, and the Far East
100 stocks traded in London
A mix of stocks traded on the Tokyo Stock Exchange
A broad-based index of about 5,000 U.S. companies
What Are Index Funds?
Index funds are mutual funds that buy and hold the stocks that comprise a market index. Thus by investing in funds that mimic the S&P 500 stock index, for example, you will achieve some measure of diversification in 500 widely held stocks traded on the major exchanges.
Index funds are passively managed, which means they purchase or sell shares of stocks only when the index replaces stocks or when investors buy or sell shares of the fund. Unlike actively managed funds, index funds do not attempt to buy stocks based on the fund manager’s outlook for certain companies or for the market in general.
The passive approach of index funds generally means the expense ratio of index funds is substantially lower than that of actively managed stock funds. The average expense ratio of index funds was 0.63% in 2014, compared with 1.22% for actively managed funds.3 The higher management expenses of actively managed funds makes it more difficult for them to outperform index funds on a consistent basis. Management fees and expenses are deducted from a fund’s results in the calculation of returns.
Using Index Funds in Your Portfolio
Proven performance, known risk levels, and diversification are advantages index funds offer. On the other hand, index funds can only be expected to do as well as their benchmark index, which may decline in a bear market. What role might index funds play in your portfolio?
Asset allocation and diversification call for more than buying just one index fund. The 500 companies in the S&P 500 index, for example, constitute only a portion of the U.S. stock market and represent only large-capitalization stocks. Other indexes are designed to track various segments of the U.S. global markets. The Russell 2000 small-cap index, the S&P 400 MidCap index (an unmanaged index of 400 stocks generally considered representative of midsized U.S. companies), and the Morgan Stanley Europe, Australasia, and Far East index (EAFE) are among the most widely quoted indexes, and there are many index funds that track these.
The variety of index funds available allows you to diversify into a wide array of stocks by indexing according to your investment goals and risk tolerance. Generally speaking, a well-diversified portfolio will include a mix of large-cap, midcap, and small-cap company shares, as well as international stocks. How much you invest in each of these markets will depend on your long-term goals and risk tolerance.4
For example, a long-term investor seeking growth might invest 50% of his or her stock portfolio in an S&P 500 index fund, 30% in midcap and small-cap index funds, and 20% in international funds.
You can also mix index funds with other stock funds or individual stocks.
Index Funds vs. Actively Managed Funds
Stocks are selected to mirror the underlying index
Risk level matches that of the index
Fees and expenses are typically lower due to infrequent trading and limited research needs
Performance is typically slightly below that of the underlying index
Actively Managed Funds
Stocks are selected based on investment objectives
Risk and return may vary
Higher fees and expenses
Potential for above-market performance
Limitations of Index Funds
If you are an aggressive investor and aim for above-average market returns, you may not be satisfied with an index fund. Because index funds track the market, they may not perform as well as actively managed funds.
Another consideration with index funds is that they may not be able to protect your investment in the event of a market downturn. Index funds are required to imitate their indexes, and their managers are usually restricted to using only very limited defensive steps. If you are a more conservative growth-oriented investor, you may be more comfortable with a stock fund that seeks to limit downside risk, but may also lag the market somewhat on the upside.
Index funds can play an important role in your portfolio, allowing you to establish a known risk level and to provide a level of return that closely matches the market’s average. By combining funds that track different types of market indexes, or by supplementing index funds with actively managed funds or individual stocks, you can build a diversified portfolio designed to seek returns appropriate for your investment time frame and goals. For more information about using index funds in your portfolio, speak with your financial advisor.
Points to Remember
Two approaches to stock selection are active and passive.
Index funds are passively managed — they mirror the risk characteristics of the underlying index.
Fees and expenses are usually much lower than with actively managed funds, helping index funds to outperform many actively managed funds.
You can use index funds to anchor your portfolio and then customize your portfolio by selecting some actively managed funds.
Some actively managed stock mutual funds have consistently outperformed index funds.
1Sources: Wealth Management Systems Inc.; Morningstar. Past performance is not a guarantee of future results. The performance shown is for illustrative purposes only and is not indicative of the performance of any specific investment. 2Source: Standard & Poor’s. For the five-year period ended December 31, 2014. S&P Indices Versus Active Funds (SPIVA®) U.S. Scorecard, Year End 2014. 3Sources: Wealth Management Systems Inc.; Morningstar. Based on all index and active U.S. mutual funds tracked by Morningstar as of December 31, 2014. 4Diversification does not ensure against loss.
This article was written for information purposes only and its content should not be construed by any consumer and/or prospective client as rebel Financial’s solicitation to affect, or attempt to affect transactions in securities, or the rendering of personalized investment advice for compensation. No client or prospective client should assume that any such discussion serves as the receipt of, or a substitute for, personalized advice from rebel Financial, or from any other investment professional. See our disclosures page for more information.
Phil Ratcliff, President of rebel Financial, is a senior financial advisor that holds an AIF®, CFP®, ChFC®, and CLU® certifications. He started his career at American Express Financial Advisors in 2003, then moved to AXA Advisors for 7 years before founding rebel Financial LLC in 2013.