investing Is Moving Up
speaking, investors have two types of
strategies to pursue: active and passive.
Recently, passive investing has gained
popularity. In 2013, for example, net
investments into passive equity funds
topped $60 billion, versus $3.4 billion
tor active funds.
you be an active or a passive investor,
or should you use both methods? To make
an informed decision, you should know
on a benchmark
Historically, investing was an active
endeavor, in today's terms. (This discussion
will focus on stocks, but the principles
apply to all investment securities.)
1: In the early 20th century, youngjohn
Smith could pick his own stocks, perhaps
based on the proverbial hot tip, or he
could buy stocks suggested by his securities
broker. In the middle of the century,
John's choices expanded. He could hire
a professional money manager to pick stocks
for him (assumingjohn had a sizable amount
to invest), or he could put his money
into a publicly offered fund and let the
fund manager select the fund for him.
all of these modes, John hoped that the
stocks he owned, directly or through a
fund, performed well. He was following
an active investment strategy.
the 20th century moved toward its end,
investors had another option: They could
invest in an index fund. Such funds do
not rely on stock picking; they allow
individuals and institutions to invest
in a broad segment of the stock market.
2: John's granddaughter Sue Jones
decided to invest in a fund that tracks
the S&P 500 Index, a benchmark for
large company U.S. stocks. This fund (and
Sue, as a shareholder) holds the stocks
in the index. As the broad stock market
goes up or down, the value of Sue's investment
flows and ebbs.
mentioned, index funds, such as the one
in which Sue invests, have become widespread.
You can find funds tracking indexes of
bonds, small company stocks, foreign stocks
and other asset classes.
example can illustrate capitalization
weighting of index funds.
500 Index Fund, a market cap mutual
fund, has over 3% of its assets
invested in Apple stock (its largest
holding), as of this writing.
indicates that the value of all
Apple shares is roughly 3% of the
value of all the shares in the benchmark
S&P 500 Index.
10 largest holdings of this fund
(including Apple, ExxonMobil, Google,
and Microsoft) make up more than
18% of the fund's assets, even though
they are only 2% of the approximately
500 companies in the index.
Assessing their appeal
With an index fund, you are assured of
participating in market moves. When large
company U.S. stocks move up by 30%, as
they did in 2013, you'll get that return
with an index fund tracking the S&P
500. You won't fall short, as you would
with an active manager who picked the
wrong stocks. Index funds tend to have
low expenses because they don't have to
support research staffs. In addition,
index funds often hold onto the same stocks,
so they may not generate unwelcome tax
bills from taking gains.
most important, many active managers have
lagged index returns over long time periods.
Although investors have tried, there apparently
is no certain way to predict which active
managers will beat their benchmarks in
With all of the advantages of passive
investing, why go active? For one reason,
there will be some active managers who
deliver returns greater than their benchmark
indexes over the next 10 or 20 years or
longer. Even modest outperformance can
make a huge difference in long-term wealth
building. In an index fund, you have no
chance of profiting from a wise manager
addition, major market indexes are primarily
"cap weighted," that is, the
stocks in such indexes are held in proportion
to the total market value of their shares.
(See the "Weight Watching" Trusted
Advice box.) At times, cap weighted indexes
become heavily tilted towards tech stocks,
oil companies, banks, or whichever market
sector is in favor. Rising prices boost
market capitalization for such companies.
When these companies lose some appeal,
as inevitably happens, the index may drop
sharply, pulling down index funds.
a better blend
Some investment companies have attempted
to improve the performance of traditional
cap weighted index funds by devising "enhanced"
indexes, then offering funds to track
those indexes. These include equal weighted
indexes: each stock in an S&P 500
index fund might be represented by Vsoo
of the fund's assets, for instance. Alternatively,
major indexes might be tweaked to give
more weight to stocks that pay dividends
or to stocks that historically have been
less volatile than the broad market.
enhanced index funds have an active component:
They're designed to accentuate some attribute
the fund sponsor believes will improve
results. Many enhanced index funds are
relatively new, so it may be too soon
to judge the success of these efforts.
However, the basic rule applies to all
funds, whether they're active or passive
or somewhere in between. Before investing,
you should know how the fund will operate
and be comfortable with its approach.
Source: September 2014 AICPA Client