With such a wide variety of investment products available, it can be confusing to know what exactly to invest in — even with easy-to-manage investments like mutual funds. Investors have a huge range of styles — from conservative to aggressive, and everything in between. Of course when trying to pick mutual funds, an investor wants a line up of top-notch performers, and not underperforming money hogs. So it’s important to know your risk tolerance, and to do your due diligence before selecting a mutual fund or group of funds.
This article aims to help you with the investing portion of your financial plan by comparing two categories of funds: index mutual funds and actively-managed mutual funds.
Simply put, an index mutual fund is an investment product designed to replicate the movements of an index of a specific financial market. For example, an S&P 500 index fund is designed to replicate the movements of the S&P 500 index. The fund manager simply tries to make the returns of the benchmark and not to outperform the market.
Index funds are perfect if you don’t want to spend the time researching and following the performance of various funds. This conservative investing approach will work if you are not trying to beat the market and simply want a slight to moderate capital growth. These funds also have a low expense ratio, and that means more money for you to keep. Lastly, they work very well in taxable accounts, because they are more tax efficient due to infrequent buying and selling of securities (low turnover ratio).
If you have time to do research and monitor fund performance, actively managed funds may be for you.
Managers of these funds stay on top of the market, buying and selling as market and economic conditions change. For example, if a downturn occurs, they often liquidate some of the fund investments to cash. This also means that they will invest more aggressively in a bull market, because their long-term goal is to beat benchmark indexes. They also tend to be more widely diversified and invest a larger variety of securities.
In term of tax efficiency, actively managed mutual funds, tend to be better suited for tax-advantaged accounts — such as an IRA or a 401(k) — because their higher turnover ratio could translate into more costs to you in a taxable account.
Editor’s Note: It should be noted that the majority of actively-managed mutual funds do not outperform index mutual funds in the long-term due to two inherent disadvantages: (1) higher expense ratio, and (2) lower tax efficiency.
In order to ensure the best performance possible with an actively managed fund, there are a few simple criteria you should consider.
The first thing to analyze is long-term fund performance. If the fund hasn’t done well up to this point, move on. If the history looks solid, the first step of analysis is complete. Of course the past performance won’t necessarily dictate future results, but having a history of outperforming the market is a definite plus.
Next, you should take the time to understand what the basic investment process is for a particular fund. Read the manager’s investment process in fund prospectus — it should be well-defined and easy to understand.
Finally, who is the management team for the fund? Again, read the prospectus carefully and find out who the fund managers are, and how long they have been involved with the fund. It’s recommended that they be actively involved with the fund for three years or more.
If you have the time to monitor your actively managed funds, this might be the right investments for you. Otherwise you may want to stick with the index funds. Keep in mind that investing for the long-term, whether buying stocks or mutual funds, is the best approach for making your retirement wishes come true. In the short-term actively managed funds often will underperform index mutual funds. Of course having a mix of index and actively managed funds in your portfolio can be great for balancing your strategy.