Posted in Finance, Accounting and Economics Terms, Total Reads: 415
Definition: Active Index Fund
It is a type of fund in which the manager makes the initial investment in the fund in proportion to a benchmark index which the manager is tracking and then invest in securities which the manager believes are undervalued or are unrelated to the benchmark index in order to realize greater returns than the benchmark index.
A fund manager attempting to create an active index fund will buy and periodically rebalance the fund in proportion to the index fund. Moreover, the manager will select individual securities which are according to the manager undervalued, overvalued or unrelated. The manager will buy undervalued stocks and sell overvalued stocks to gain excess returns from the market. Active index fund can also have a goal to reduce volatility (risk) of the entire portfolio with the same return as the benchmark index or even higher than the index.
Active index funds lead to high transactions costs because of high turnover of index securities, which could eat up the returns generated by active management. Though, active index funds aim to outperform the market, these funds can also miss their goals and lead to losses for the fund as well as the investors. The performance of an active index fund depends upon the research, market forecasting, experience and expertise of the fund manager or the management team.
For example: An active index fund manager believes that the automotive sector will outperform other sectors this quarter, then the manager will invest more in automotive sector. Or, within a sector, if the manager believes that market price of company X’s stock is not its true price and is undervalued, the manager will buy the stocks of X to earn greater returns. Similarly, if the manager believes that the stock of company Y is overvalued and the price will fall in near future, the manager will short sell the stock. Both the strategies can also be used simultaneously.