One of the key elements of retirement accounts is the selection of investments that allow us to grow our money over time and accumulate savings for the future. It’s helpful to understand the types of investments available so that we can make informed decisions about where we invest. Here we discuss two types of common funds and their differences: index and active investments.
Index Investments
When it comes to making myself a weekday dinner, I like to keep things pretty simple. I generally choose a protein, a vegetable, and a starch to help ensure I have a balanced meal. I keep it convenient and simple when it comes to seasoning by using pre-mixed seasonings. On top of this being a pretty easy strategy to follow, it’s also cost-effective because of its simplicity. In many ways, these meals are similar to index investing.
Index investments have many of the same benefits as my weekday meals at home: they’re simple, balanced, and cost-effective.
With index investments, an investment company — let’s use the example of “ABC Company” — will invest money in a pre-determined index, such as the S&P 500. There are many examples of indexes in both stock and bond investments, including the S&P 500, Russell 1000, and Bloomberg U.S. Aggregate Bond Index. These indexes invest in a large number of companies or bonds and don’t make frequent changes. For example, the S&P 500 invests in the 500 largest stocks listed on the U.S. stock market and weights them based on their size (bigger company = larger percentage invested).
Because this strategy is simple it can be done at a very low cost, therefore the cost to invest in index funds is typically very low. In theory, an index investment will perform well over time because it’s simple, diverse, and low-cost.
Within your account, index funds will generally include “index” in the name to help identify them. An example would be “ABC Company S&P 500 Index Fund.” A fact sheet or prospectus gives you more information on the goals of a particular investment fund and states if the goal is to track an index.
Active Investments
Now and then, I get tired of my simple weekday meals. To break up the monotony, I go out to a restaurant. A chef at a restaurant uses more complex techniques and ingredients than I do at home. I can also choose restaurants that specialize in certain cuisines, like Italian, Mexican, or Chinese. Because of these specialties and the team of people working to make these meals, they also cost a bit more than my home-cooked meals.
Active investments are similar to eating at a restaurant. They are a bit more complex and may cost more.
With active investments, an investment company — like “XYZ Company” — will have a management team to determine how money is invested. This may include portfolio managers, analysts, and traders. Rather than following an index, this team will usually try to outperform an index. They may invest differently than the index and take advantage of possible inefficiencies. For example, if they believe certain companies in the S&P 500 are undervalued, they may choose to invest more money in that particular company.
Again, because of the complexity and the team of people it takes to invest actively, these investments generally cost more than an index fund. However, the benefit is that their goal is to earn better performance than the index and may do so. Just like eating at a restaurant though, there is no guarantee the meal you pay extra for will be delicious. Active investments aim to outperform and index, but there is no guarantee that they will do so.
Within your investment line-up, the active fund will generally not include an “index” in the name. An example would be “XYZ Large Cap Growth Fund.” A fact sheet or prospectus will give you more information on the goals of a particular investment fund.
What’s Better?
It depends. Eating at home all the time can become boring, but eating at a restaurant all the time could be unhealthy or costly. Both have advantages and disadvantages.
A balanced approach may make the most sense. Steering away from either type of investment could lead to you missing out on investment performance. There will likely be times when index funds outperform active managers, and there will be times when active managers outperform index funds. A balanced approach diversifies your holdings and ensures that you can take advantage of the benefits of both indexing and active management. Learn more about index, active, and other types of investments and find more tools to help you achieve your savings goals at u.bpas.com.