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| The Indexing Question:
Active versus Passive |
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Paper or plastic? Credit or debit? Your life is full of choices. You have lots of options when you invest, too. One of your biggest decisions is between investing in index funds or actively managed funds.
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Buying an index fund is a simple way for you to invest in a particular part of the market (such as large-company stocks, for example). Index funds track a particular index (such as the S&P 500) and attempt to match its returns by buying all or most of the stocks (or bonds) listed in the index. If the fund is successful, it earns you exactly what the index gains, minus the cost of running the fund. You can access an index fund through a mutual fund or an Exchange Traded Fund (ETF). An ETF is a type of fund that trades throughout the day over an exchange. ETFs usually have lower annual expenses than mutual funds, but you must pay commissions to trade them. As a side note, you can’t invest in an index directly—you have to do it through a fund.
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The theory behind indexing is simple. In every market there are winners and losers. Instead of trying to figure out which stocks are which, index funds grab them all. So, while your index fund might not be at the top of the heap, it probably won't be at the bottom, either. And index funds are usually, though not always, less expensive than other types of funds, which means you get to keep more of the money you earn.
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But maybe you think there are people who can pick the winners. If so, you'll want an actively managed fund. Active Management refers to the attempt by a fund manager to deliberately pick and choose specific investments that will perform better or be less risky than other investments. Most mutual funds, other than index funds, use active management, though different managers use different methods to pick their investments.
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However, there's one problem with actively managed funds: figuring out which funds to choose. Because you can't predict the future, you can never be sure the fund you're buying will beat the index.
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Luckily, you don't have to invest just in passive index funds or just in actively managed funds. You can combine the two in any way you like. Either way, remember to stick to solid performers with reasonable costs and good track records.
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