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Active vs. index funds

Imagine yourself suddenly dropped into the center of your hometown after a lengthy absence. You have 20 minutes to get to the airport, far out in the suburbs. Would you prefer to drive yourself, given your extensive, though not recent, knowledge of the back roads and shortcuts of your birthplace? Or would you rather take a taxi, figuring the driver may be more informed on routes, road closures and detours?

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Investors face a similar head-scratcher when it comes to choosing between the index (or passive) mutual funds you drive and actively managed (or active) funds that leave the driving to others. Both can get you where you want to go -- a financially sound retirement -- but chances are you'll prefer one ride to the other.

"There's just not a one-size-fits-all portfolio or rule of thumb," says Sonya Morris, fund analyst for Morningstar. "It's going to depend on the investor's risk tolerance, objectives and time horizon."

The debate over index vs. actively managed funds has raged so long without resolution that it has taken on the rich patina of the great sports rivalries. As with all great rivalries, both sides are somewhat evenly matched, have their unique strengths and weaknesses, and prevail and disappoint in about equal measure.

Index vs. active funds

Get your pencils and scorecards ready. Here are the team lineups:

Index funds
Index funds invest in equity or fixed-income securities specifically to replicate indexes such as the Standard & Poor's 500 or Lehman Brothers U.S. Aggregate. Index funds are recommended as solid, long-term core investments.

Strengths: Because the holdings in these funds are closely tied to their respective indices, there is little in the way of buying and selling (called "turnover") or management involved, resulting in minimal cost to investors. For example, the popular Vanguard 500 Index fund charges only 18 basis points (0.18 percent) in fees. Index funds also are well-diversified and easy for even a novice investor to purchase.

Weaknesses: Because index funds by nature do not correct for market conditions, they passively go in the direction of the market, both up and down. This can sometimes try the patience of investors, particularly during periods of volatility.

Some financial advisers, including "Die Broke" author Stephen Pollan, find index funds safe but pretty ho-hum.

"Index funds do not have the advantage of having stocks picked for quality, for performance at the time," he says. "Bringing this down to basics, index funds are cheaper but you're missing good judgment."

 
 
Next: "Past performance is no guarantee"
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