Active Index Fund - Explained
What is an Active Index Fund?
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Table of ContentsWhat is an Active Index Fund?How Does an Active Index Fund Work? Limitations of an Active Index FundAcademic Research on Active Index Fund
What is an Active Index Fund?
An active index fund refers to a basket of assets which holdings from a benchmark index is used by the fund manager to construct the initial investment. The fund manager then includes securities that are not related to the underlying index that's capable of increasing performance. The aim of this additional layer of non-benchmark securities is to greatly increase returns above the traditional passive strategy of buy and hold. By adding individual stocks separated from the broader index, the fund manager will be able to unlock additional alpha.
How Does an Active Index Fund Work?
An active index fund tries to take an index fund version such as the 500 Index of Standard & Poor (S&P 500) and recurrently rebalance every stock to correspond with the proportions found in the real S&P 500. Stocks would be added by the manager to any fund that's believed to yield more returns to the passive index fund. For instance, if the manager has the conviction that semiconductors would produce favorable results for future quarters, then there would be an addition of more semiconductor stocks to the portfolio. While there is the possibility of some fund managers significantly beating the underlying benchmark by utilizing techniques such as market timing, this is far from assured. Passive funds can be trusted to faithfully follow an index, which makes it possible for investors to be knowledgeable of the fund's true holdings, as well as, risk profile. This is beneficial to investors as it helps them keep managed expectations and a diversified portfolio. The investing community finds it difficult to anticipate the future composition of the fund once an active layer has been added to the index fund. This can work for investors during times of heavy market volatility and the fund needs an expert to limit drawdowns. Allocations can be shifted away by a fund manager from underperforming positions to suitable asset classes or sectors. Nevertheless, a majority of empirical research shows that a simple passive strategy likely outperforms a complex active management approach.
Limitations of an Active Index Fund
Despite the fact that an active index fund holds a lot of the same securities as a traditional index fund, they likely come at a premium. When an active management style is taken, it means that the fund must charge more fees in order to cover the cost of research materials, the manager, and any other data needed to make favorable investment decisions. These higher expense ratios pressurize fund managers to constantly beat or outperform the underlying index. As with mutual funds, the potential to perform better is dependent on the manager. While some have a knack for discovering hidden gems, most would choose losing assets which limit the fund's potential performance.
Academic Research on Active Index Fund
- The governance impact of index funds: Evidence from regression discontinuity, Mullins, W. (2014). The governance impact of index funds: Evidence from regression discontinuity. Work. Pap., Sloan Sch. Manag., Mass. Inst. Technol.
- SEEKING ALPHA--PERFORMANCE OF LATVIAN SECOND LEVEL PENSION FUNDS., Lieksnis, R. (2009). SEEKING ALPHA--PERFORMANCE OF LATVIAN SECOND LEVEL PENSION FUNDS. Economics & Business, 18. This study investigates whether Latvian second level pension funds can outperform equity and fixed income market indexes on a consistent basis. Findings confirm the conclusion of similar studies worldwide that it is very difficult to achieve outperformance hence none of the analyzed pension funds manage to achieve positive Alpha. The quarterly returns of 12 pension funds are analyzed for the time period from 2003 till 2009. The study proposes to use a representative bond market index as the benchmark of pension fund performance on a relative basis.
- Beating a Benchmark by Actively Managing its Components: The Case of the Dow Jones, Basu, D. (2005). Beating a Benchmark by Actively Managing its Components: The Case of the Dow Jones.
- Essays in financial economics, Mullins, W. (2014). Essays in financial economics (Doctoral dissertation, Massachusetts Institute of Technology). This thesis examines three questions in Corporate Finance. The first chapter investigates the effect of institutional ownership on the governance dynamics and behavior of firms. I exploit the exogenous change in equity index membership generated by the reconstitution of the Russell indices. Following reconstitution, I show that firms just included in the Russell 1000 index have higher institutional ownership (IO) concentration than those just excluded - both a change in indexers and a change in active 10, suggesting a complementarity between these types of investors. Firms just included in the Russell 1000 increase the performance sensitivity of their CEO's pay, have a higher likelihood of CEO turnover, and have lower capital expenditures. Overall, these results suggest a significant impact of institutional preferences on corporate behavior. Chapter 2, joint with Antoinette Schoar, shows that CEOs' management styles and philosophy vary with the control rights of the founder and/or owning family, using a survey of over 800 CEOs in 22 emerging economies. CEOs of firms with greater family involvement have more hierarchical management, feel more accountable to stakeholders than they do to shareholders and see their role as maintaining the status quo rather than bringing change. In contrast, professional CEOs of non-family firms display a more textbook approach of shareholder-value-maximization. Between these types we find a continuum of leadership styles and philosophies that vary with how intensively family members are involved in management. Chapter 3 examines whether and how companies benefit from campaign contributions. To obtain exogenous variation in such political connections, I use U.S. congressional elections that were decided by less than 1% of votes in a RDD. Such close elections are akin to randomized assignment: Prior to the election, companies' political connections have similar expected values. My estimates suggest that companies connected to the winning candidate experience both a significant increase in long-term firm value and a positive short-term stock market reaction around the election date. I further document evidence supporting four channels through which political connections may enhance firm value: 1) allocation of procurement contracts, 2) reduced legislative and regulatory risks, 3) improved bank financing, and 4) improved access to lobbying.
- Asset allocation in the South African environment, Mahoney, K. (2014). Asset allocation in the South African environment (Doctoral dissertation, University of Cape Town). The aim of this paper is to find solutions to the asset allocation problem in the South African environment. These solutions look at a variety of different investor's preferences. These include an investor's age, risk aversion and required levels of returns. To do this, an analysis was done of prior research, so the most up to date mean-variance asset allocation model could be developed. Returns from 10 different indices, over different asset classes were gathered. The indices of importance were found to be: All Bond Index (ALBI), Inflation Linked All Maturities Index (ILB), Salient's Momentum Active Index Fund (MOME), Salient's Value Active Index Fund (VAL), South African Short Term Fixed Interest Index (STEFI) and South African Property Index (SAPY).