Actively V.S. Passively Managed Funds

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What Is an Actively-Managed Fund?
The portfolio manager of an actively-managed fund tries to beat the market by picking and choosing investments. The manager performs an in-depth analysis of many investments in an attempt to outperform the market index -- like the S&P 500. What Is an Index Fund?

Index funds are considered to be passively managed. The manager of an index fund tries to mimic the returns of the index it follows by purchasing all -- or almost all -- of the holdings in the index. Hundreds of market indexes can be invested in via mutual funds and exchange-traded funds. Should You Own Actively-Managed Funds or Index Funds?

The potential to outperform the market is one advantage that actively-managed funds have over index funds, and this notion of outperformance is attractive to investors. After all, why settle for an index fund when you know you will only receive the market return, less a nominal fee, to the fund’s manager? Unfortunately, evidence that actively-managed funds can consistently outperform their relevant index is difficult to find. It’s even more challenging for an individual investor to identify which actively-managed fund will outperform the index in a given year. According to Vanguard, for the 10 years leading up to 2007, the majority of actively-managed U.S. stock funds underperformed the index they were seeking to outperform. For instance, 84% of actively-managed U.S. large blend funds underperformed their index, and 68% of actively-managed U.S. small value funds underperformed, as well. The case is even worse for actively-managed bond funds. In that case, almost 95% of actively-managed bond funds underperformed their indexes for the 10 years leading up to 2007. Luck or Skill?

You might point out that some funds indeed beat their indexes, so why not buy those? Well, how do we know whether the active manager was skilled in his or her investment selection, or was just lucky? The evidence from a Barclays Global Investors study shows...
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