This essay set out to know which type of investment is better for a retail investor. By this, we will consider the meaning and operations of an index tracker fund, as well as that of actively managed funds. Also I identify the advantages of index-tracker funds over actively managed funds and the conclusion in relation to the topic.
Retail investors are small investors with a very small capital to invest. They only buy securities in smaller quantities or retail, thus called, retail investors. Retail investors purchase and manage their investment personally or through investment clubs and brokers. (Investopedia, n.d, investing answers,n.d).
An index is a group of securities which gives reports of variations in the activities of a stock market. Index-tracker Funds is a collective investment scheme usually a mutual fund or exchange-traded fund, that aim to replicate the movements of an index of a specific financial market or the set of rules of ownership that are held constant, regardless of market conditions. Index tracker fund managers track indices which measures the performance of larger amounts of securities with the aim of being able to follow up easily with the overall achievements of the market at a minimal expense. Index trackers are sometimes referred to as passive funds included in some popular stock index such as Nikkei 255, S&P 500 and FTSE 100.[David Stevenson(2011)].
According to Lee McGowan Actively managed Funds is a pool of liquidity with a portfolio that an investment company trade actively in order to meet the fund's investment objectives. The active managed funds are different to the passive investments which are centralized, the portfolio is equivalent to the weight ratio of the price index in the entire market, and the income will have fluctuations with the current price index. Retail investors should invest in index-tracker funds rather than in actively managed funds due to the following;
Index investing uses passive operation of tracking the benchmark index, which can make the cost of the fund's operating and transaction into a minimum. Lower management fee will be charged, on the other hand, the index investors tend to buy a long term holders of stocks, as opposed to active management by actively trading the formation of high turnover and must pay higher transaction costs, the investment of index tracker funds does not take any adjustment to the investment portfolio initiatively, and low cost of turnover transaction will be paid. This is different compared with the actively managed fund.[John Boggle ,R. Powell (2008)]
Individual investor in collective investment avoids management risk. The performance of actively managed funds can, during any periods of time, vary considerably. Some will outperform stock index and others will underperform. If the direction and size of the deviation from the index occur by chance. Individual investors run the risk that their chosen funds may relatively perform poorly; by investing in index funds they avoid this management risk. (Keith Redhead,2008)
Index Investing can postpone long term capital gains in order to achieve the delay of paying the income tax. Because the index funds take the long term holding as a strategy, and the rate of turnover is very low, the capital gain will often hanging in the account instead of changing into cash, it can be indefinitely delay the tax. And if the index funds will reinvest the proceeds, the utilization of funds will step into a higher level.
The management of active managed funds is often unable to go beyond the performance of the long term index; Historical experience tells us that the numbers of managers of active managed fund in the world who can continue to beat the index funds are very rare. The famous research institution (Morning star) obtained over the near 20 years concluding that the return on investment of index fund is better than 80% of the actively managed fund, showing the need and value of index fund's existence.
Because the index funds do not make the decision of the investment initiatively, the fund managers do not need to supervise the performance of the funds. Index funds manager's main task is monitoring the corresponding changes of index, to ensure that the combination of index funds will follow the changes themselves. Actively managed fund is based on the superiority of information and use the independent judgment to make the investment. The actively managed fund is different to passive investment which is decentralized, the portfolio is equivalent to the weight ratio of price index in the entire market, and the income will have the fluctuations with the current price index. Beside the active managed fund usually do the regular trading of bonds instead of holding the bond to the end.
Index tracker funds ensure that the portfolio remains diversified. Actively managed funds, in their attempts to outperform the market, may hold poorly diversified portfolios. For instance they may tilt the portfolio towards particular sectors. Actively managed funds hold inadequate diversified portfolio, they sacrifice part of the risk indices, some of index-tracker funds, can be concentrated on a few sector. (Keith Redhead,2008).
Studies have shown that more than 90% of the long term return comes from the allocation of asset, and the index investing is the most direct way to allocation of asset. Example the global pension fund to asset ratio of passive management has always played a large proportion of pension fund in which the larger the system the more perfect state.
No style drafts. A style draft occurs when actively-managed mutual funds go outside of their described style (mid-cap value, large cap income) to increase returns. Such drift hurts portfolios that are built with diversification as a high priority. Drifting into other styles could reduce the overall portfolio's diversity and subsequently increase risk. With an index fund this drift is not possible and accurate diversification of a portfolio is increased.(investopedia)
Also, We should consider the factor of efficient market. The efficient market is the one which is fully reflect all known, relevant information, and adjust unbiased manner to any piece of new information. The investor should assume that it will be very difficult to outguess the market on any consistently outperform the market and so it is pointless to pay its management fees. And at this point the cost index funds should be a good choice for the retail investors. However the efficient market hypothesis is doubted by evidence from behavior finance (Brealey and Myers)
However, the index tracker funds is subjected to some drawbacks which making it unsuitable for retail investors.
Possible tracking error from index. Since index funds aim to match the market return, both under and over performance compared to the market is considered a "tracking error". For example an inefficient index fund may generate a positive tracking error in a filling market by holding too much cash, which hold too much cash, which holds its value compared to the market. (A.Tergesen (2007).
No fund manager discretion. Tracker funds do not have the flexibility to avoid shares, sectors or industries going through a difficult period. For example, in 2008 many active fund managers reduce their exposure to banks when the financial crisis hit, which helped them to avoid the worst falls in the stock market. Tracker funds had to maintain their exposure to banks and therefore the associated falls.
Index composition charges reduce return. Whenever the index changes, the fund is faced with the prospect of selling all the stock that was added to the index. The S&P index has typical turnover of between 1% and 9% per year. in effect the index and consequently all funds tracking the index, are announcing ahead after time the trades that they are planning to make. as a result, the price of the stock that has been added to the index tend to be driven up, In part due to arbitrageurs, in a practice known as "index front running". The index fund, however, has suffered market impact cost because it had to sell stock whose price was depressed and buy stock whose price was inflated. These loses can, however, be considered small relative to an index fund's overall advantage gained by low costs. [Standard and poor's(2007)]
The index tracker cannot outperform the target index. By design, an index fund seeks to match rather than outperform the target index. Therefore a good index fund with a low tracking error will not generally outperform the index, but rather produces a rate of return similar to the index minimum fund cost.
On the other hand actively managed funds have advantages for the investors who have large amount of funds which are as follows:
The ability to react to the market conditions and adjust the portfolio accordingly. The fund manager can raise cash level when they anticipate a correction is coming in the equity market. This allows the funds to suffer smaller losses when the market drops.
Conversely, some investors may want to take on additional risk in exchange for the opportunity of obtaining higher-than-market returns.
Some investors may wish to follow a strategy that avoids or underweight's certain industries compared to the market as a whole, and may find an actively managed fund more in line with their particular investment goals. (For instance, an employee of high technology growth company who receives company stock or stock options as a benefit might prefer not to have additional funds invested in the same industry.)
[Burton G. Malkiel (2011)]
Conclusion. In summary index investing can achieve a diversified portfolio with a small amount of money, and the risk is fragment, besides it has a stable earning. As the basic index can refer to historical data, the risk is measurable, which to some extent making sure that the investor of index can avoid risk of unknown. The index tracker funds has low transaction costs, since index funds tracks a particular index, and buy the share according to the institution index. What's more the fund will do a diversified investment. These are the reasons why any fluctuation of single share will not have an effect on the whole performance of the index funds. But the actively managed funds have an advantage of making good use of the opportunities of structure. By using the exchanges of ups and downs between the inter-industry and stock market styles, the actively managed fund get better returns than index funds according to different market conditions. Especially when the market are in the fluctuations within a certain range, active funds in the industry and the advantages of flexibility in individual stocks will be more apparent. What's more with a better control of the proper position, the chance of active managed fund winning the index funds will be increased heavily. But we must know that all these could happen under a premise that the active managed fund managers must have deep research of listed companies, including fundamental analysis and technical analysis. Actively managed funds have high costs, low probability for success and payout doesn't justify the risk, and investors who buy actively managed funds can't be engaging their brain to calculate probability. They must be focusing on the possibility of a high return. Due to these reasons the actively managed- funds are not suitable for the retail investors.
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If the market can not reflect the information, can retail investors choose the index fund instead?
According to Malkiel holds an option that even if the market is not an efficient one, retail investor should choose index funds because his pint that the investment out-performs the market there will definitely the other managers underperform the market. We know that the market will perform following the market itself, and it is the same as it to index fund. This has resulted in that the index funds minus the market will therefore perform following the market. From Malkiel's opinion, we know that if some actively managed portfolios outperform, there will be definitely the others that are in under-perform the market.
