One of the most basic distinctions among 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 index funds.
What Are Index Funds?
By investing in an index fund that mimics the S&P 500 stock index, for example, an investor could achieve some measure of diversification in 500 widely held stocks traded on the New York Stock Exchange, the American Stock Exchange, and Nasdaq.1
Index funds 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 0.75% in 2011, compared with 1.24% for actively managed funds.2 The higher management expenses of actively managed funds make 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 Within a Portfolio
Asset allocation and diversification may require buying more than one index fund.3 The 500 companies within the S&P 500 index, for example, constitute only a portion of the U.S. stock market and represent only large-capitalization stocks. The Russell 2000 small-cap index; the S&P 400 MidCap index (an unmanaged index of 400 stocks generally considered representative of the U.S. midcap market); and the Morgan Stanley Europe, Australasia, and Far East index (EAFE) are among the most widely quoted indexes; there are many index funds that track these.4 The variety of index funds available allows investors to diversify into a wide array of stocks by indexing according to investment goals and risk tolerance.
Index Funds Versus Actively Managed Funds
Actively Managed Funds
1Standard & Poor’s Composite Index of 500 Stocks is an unmanaged index that is generally considered representative of the U.S. stock market. It is not possible to invest directly in an index. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.
2Sources: Standard & Poor’s; Morningstar. Based on all indexed and active U.S. mutual funds tracked by Morningstar as of December 31, 2011.
3Asset allocation does not assure a profit or protect against a loss. There is no guarantee that a diversified portfolio will enhance overall returns or outperform a nondiversified portfolio. Diversification does not ensure against market risk.
4Securities of smaller companies may be more volatile than those of larger companies. The illiquidity of the small-cap market may adversely affect the value of these investments. Foreign investments involve greater risk than U.S. investments, including political and economic risks and the risk of currency fluctuations, and may not be suitable for all investors.
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