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An active index fund is an investment with a base that matches the funds in a specific index, which is then supplemented with unrelated stocks with the purpose of beating the market average. The success of this kind of fund depends upon the investor’s choices and involvement. Its management typically consists of two primary tasks: matching and regularly rebalancing the funds in the underlying index and buying and managing non-benchmark stocks.
The first task of creating an active index fund is to pick an index to track. Once this has been determined, the investor will buy the stocks in the index in the same proportions as benchmarked by the fund. These investments are typically managed separately from the other investments in the fund so that they can keep pace with the market and its target index. The fund manager will usually consider some elements of the index, such as the nature of its investments and its success in the market, when making decisions about investing in the active funds.
Funds that are not related to the targeted index are the active part of an active index fund. These investments require more management than the funds in the underlying index. The goal of investors using this method is to pick stocks they believe will perform better than that index. Investors will typically use funds they believe will perform well according to forecasts, past performance, and other individual factors not related to the index. It is this portion of the investment with which the investor will attempt to beat the market.
There has been little evidence to support the effectiveness of an active index fund. While it can frequently beat the market, it does not appear to be able to do so with any consistency. Statistically, these funds tend to underperform the index they are meant to beat. Though an index fund is essentially meant to simply keep pace with the market, it often appears to be a more sound investment than an active fund.
An active index fund is also usually more expensive to maintain, as there are more frequent fees for the increased involvement of the fund manager. In some cases, these expenses may be so high that they cancel out any gains made by the active portion of the fund. There is also the potential to lose money when the selected funds perform poorly and yet there are still extra fees to be paid.