What Is an Active Index Fund?
An active index fund consists of a basket of assets thatthe fund manager constructs from both securities in a benchmark index and securities unrelated to that index. The manager may alter the lineup of index securities that the fund contains by removing certain benchmark index components.
Key Takeaways
- An active index fund seeks to combine the positive aspects of passive indexing with active portfolio management.
- Examples of active index strategies include a tilt or smart beta approach, the latter of which seeks to exploit pricing inefficiencies while adhering primarily to an index.
- Active index funds may underperform purely passive funds.
- They often charge investors higher management and transaction fees than passive index funds.
Understanding Active Index Funds
The goal of the active index fund is to drive portfolio performance higher than that offered by the index. The additional layer of actively managed non-benchmark securities is used to boost returns above a traditional buy and hold passive strategy .
By adding individual stocks that aren't included in the broader index or by weighting stocks more heavily than the index, the fund manager can unlock additional alpha.Active index funds may employ a tilt or use a smart beta strategy.
Active Management
The active fund manager will add stocks to the fund that they believe will yield returns above and beyond those offered by a passive index fund.
For example, if the manager believes semiconductors will produce strong results for future quarters, more semiconductor stocks would be added to the portfolio.
Active vs. Passive Management
While it is possible for some fund managersto significantly beat the underlying benchmark index with strategies like market timing, this is far from guaranteed.
Passive funds can be counted on to follow an index faithfully, which allows investors to know the true holdings and risk profile of the fund. This helps investors maintain diversified portfolios and manage expectations.
Adding an active layer to the index fund makes it difficult for the investing community to anticipate the future makeup of the fund. This can work for investors when the market experiences heavy volatility and the fundrequires a trained professional to limit drawdowns.
An active fundmanager can shift allocationsaway from underperforming positions to what they project is a more appropriate sector or more attractive asset classes.
However, most empirical research finds a simple passive strategy tends to outperform a complicated active management approach.
Tilt Funds
A tilt fund is a type of mutual fund or exchange-traded fund that includes a core holding of stocks that mimic abenchmark-type index, to which additional securities are added to help tilt the fund toward a performance that beats the index.
Sometimes calledenhanced index funds, these are active index funds used by major investors to improve overall investment returns.
A fund that utilizes a tilt strategy might have the vast majority of capital invested in S&P 500 companies. But it might also allow the manager the flexibility to include other stocks as well.
Value tilts in a fund may also call for one type of stock over another, such as small-cap stocks that historically have provided higher-than-average returns.
Smart Beta Funds
Smart beta strategies seek to passively follow indices and incorporate alternative weighting schemes involvingvolatility, liquidity, quality, value, size, and momentum.
They are implemented like typical index strategies, in that the index rules are set and transparent. However, these funds don’t track standard indexes, such as theor the Nasdaq 100 Index, but instead, focus on areas of the market that offer an opportunity for exploitation.
There is no single approach to smart beta, as the goals for investors can be different based on their needs. However, some managers are prescriptive in identifying smart beta ideas that create value and are economically intuitive.
Equity smart beta strategies seeks to address inefficiencies created by market-capitalization-weightedbenchmarks. Funds may take a thematic approach to manage this risk by focusing on mispricing created by investors seeking short-term gains.
The latest S&P Indices vs. Active study (SPIVA) shows that the majority of active managers of stock funds fail to outperform the indexes associated with their funds. This is especially evident over long periods of time.
Limitations of Active Index Funds
Although an active index fund holds many of the same securities that a traditional index fund holds, it tends to cost more than the index fund.
An active management style means that the fund must charge higherfees to cover the costs of the manager, research materials, and any other data required to make investment decisions in line with the purpose of a fund.
These higher expense ratiosputpressure on fund managers to consistently outperform the underlying index.
As with any actively managed mutual fund, the potential to outperformcomes down to the manager. Some have a knack for finding hidden gems. But most fail at selecting winning assets and/or successfully timing the market. This pitfall of active management can limit a fund's performance potential.
Example of an Active Index Fund
The Flexshares Morningstar U.S. Market Factor Tilt Index Fund is an example of an active index fund. This particular fund seeks to capture investment results that generally track the price and yield performance (before fees and expenses) of the underlying Morningstar US Market Factor Tilt Index.
According to Morningstar, the Flexshares Morningstar U.S. Market Factor Tilt Index "measures the performance of US equity markets with increased exposure toward small-capitalization and value stocks. Stocks that are deemed to be small-capitalization or value will have an overweighting compared to their weight in a corresponding market capitalization-weighted index."
Thus the fund's objective is to seek the growth potential of U.S. small cap and value stocks.
Are Active Index Funds a Good Investment?
That depends on your investment objective and preference for active or passive management. You get a mix of a passive index fund and active management strategies in these funds. So it's important to understand what each involves. Bear in mind that active fund managers normally underperform their benchmark indexes.
Are Active Index Funds More Expensive?
Usually, they are more expensive than passively managed index funds because of the costs associated with having fund managers actively seek out securities they feel will help their funds outperform corresponding indexes. However, if they succeed at capturing greater returns for investors, the cost may be worth it.
Does an Active Index Fund Involve Market Timing?
Typically, yes. Active management and market timing normally go hand-in-hand. Timing the market is a challenge for all active managers and some are better at it than others.
The Bottom Line
An active index fund is essentially a fund designed to track a benchmark index and allow for the active buying and selling of securities by managers attempting to beat the benchmark index's returns. Tilt funds and smart beta funds are examples of active index funds.
Active index funds have higher expense ratios than passive index funds due to the costs associated with active management.
