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.
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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.