Mutual funds investors are always confronted with the decision about investing in managed funds or using an index fund. There are plenty of people who believe one is better than the other, so we will review the advantages and disadvantages of each and I will provide my suggestion to help you out.

 Actively Managed Funds: All mutual funds that are actively managed by a fund company to add value to shareholders returns fall into this category. In theory, an experienced portfolio manager can surpass the returns of an index fund by making well-timed and disciplined trades. Unfortunate, the vast majority of fund managers do NOT beat their index. But the good news is that the top 20% of these funds can and do on a regular basis. We will try to focus on this group of quality managers.

Advantages: The main advantage of active management is that quality managers use their experience, analytical skills, and economic research to help find undervalued investments that are ready to outperform the market. They can focus their buying on the areas that they find most attractive and sell or avoid those that are under-performing. An active manager can take advantage of market dips to buy or sell as necessary which can add value to your investment.

A great management team can add several percentage points to your overall return each year, and this can add up over time. Your net returns, even after higher expense charges, can be noticeably higher than an index fund.

Disadvantages: Along with the increased buying and selling activities of an active manager comes a higher expense charge for those trading and management costs. Most actively managed funds have a 50 to 100% higher operating expense ratio than the average index fund. If you are not getting better returns, this can cost plenty over time. Also, if your quality manager leaves the fund, you may need to find a better alternative.


Index Funds: Any fund that is made up of a static portfolio structured to mirror the investments of a proposed market index is classified as an index fund. There are small cap indices, bond indices, international indices, specialty indices and many others. The most widely used are the S&P 500 index where the fund uses the same 500 stocks that are included in the Standard and Poor’s 500. These portfolios are only changed when and if the index changes its holdings which allow for a very tax efficient, low turnover investment.

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Photo by 401(K) 2013

Advantages: Index funds provide a static and very transparent investment portfolio. They also offer very low turnover of securities due to less buying and selling. This allows them to keep operating expenses at a minimum and usually substantially lower than their managed counterparts. The fact that they represent the entire stock or bond holdings of the index provides great diversification, which can also be a disadvantage.

Disadvantages: Because these funds are not actively managed, you cannot weed out under-performing securities from the overall index. This can and does have a detrimental effect on your returns. If market conditions warrant action, index funds usually will not be altered unless it happens to coincide with their regular rebalancing schedule.

If you are thinking that because you own several of the most popular index mutual funds, your investment portfolio is already properly diversified; you may be in for some rude re-awakening. Having several funds in your portfolio mix is not a guarantee that you have covered all the bases. If fact, it may result in fund overlaps which can effectively reduce the benefits of diversification.

Fund overlaps result from having two or more funds that have positions in the same securities. This can kneecap your entire investment portfolio, especially if those same securities present in two or more of your funds suffer a negative loss. In other words, it unnecessarily exposes you to greater risks since you are holding on to more of the same kind of security.

It negates the primary reason why you need to diversify – which is to have adequate downside protection. It protects your portfolio from going under in case one sector goes haywire and delivers poor performance. Having fund overlaps also mean part of your capital is unnecessarily tied to the same security, effectively limiting your upward exposure.

Having fund overlaps is unavoidable, particularly if you obtain different funds from different companies with different managers. Each one of these fund managers is likely to include the most popular and most profitable security in their respective mixes, causing a fund overlap if you include them in your portfolio mix. Small amounts of overlaps are tolerable. However, extreme overlaps can turn your portfolio into a lame duck.

What you need to do

There is no easy way to check for overlaps. The best thing to do is to check each fund every quarter and compare the top holdings of each fund with one another. If two or more of the funds have overweighed the same security, then you may consider retaining only one of the funds and replacing the other (or others) with another fund (or funds).

Checking for overlaps in your mutual fund holdings can be difficult and tedious. You can pay for a service to check for overlaps or you can manually analyze and compare the top holdings of each of your funds.

It is easier, though to avoid overlaps if you are just starting your investment portfolio. The secret is to choose funds with different objectives. That way, you can be almost sure that there won’t be an overlap in their top holdings.



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