Index trackers, or funds, invest in shares that track a particular stock market index, such as the S&P 500. Picking stocks involves researching company fundamentals and buying those that meet certain investment criteria. Index tracking is a passive investing strategy because the portfolio mix usually remains the same. Stock picking is an active strategy because it involves buying and selling shares based on market conditions and business fundamentals.
Index trackers include index mutual funds and exchange-traded funds. Index mutual funds track different types of indexes, including major market indexes, industry sector indexes and proprietary indexes. ETFs also track different market indexes and trade on regulated exchanges just like stocks. Stock picking involves accumulating positions in quality stocks at reasonable prices and reducing positions in stocks that are overpriced or have deteriorating business conditions.
Index tracking is usually less expensive than picking stocks. Index trackers require minimal research because the composition of the index has already been predetermined. Stock picking expenses are higher because of ongoing research and transaction costs. Investors and portfolio managers have to research potentially dozens of companies and actively monitor the markets for the right buying and selling opportunities.
Diversification means investing in different industry sectors and within several companies in the same sector. Index trackers have built-in diversification because the tracked indexes typically consist of dozens or hundreds of stocks. For example, the index trackers for the S&P 500 index are automatically diversified across 500 companies in all industry sectors. Geographic diversification is also possible through ETFs that track global stock indexes. It is difficult and expensive to achieve that level of diversification by picking stocks. However, individual investors can achieve superior returns by focusing on a handful of quality stocks in industries they can understand and evaluate.
The return for index trackers should come very close to the return for the tracked indexes. For example, if the S&P 500 gains 10 percent, its index trackers should gain about that amount minus nominal management fees. Stock picking should produce superior returns because of the focus on a handful of stocks instead of dozens of stocks in an index. In the competitive mutual fund industry, portfolio managers of actively managed funds are expected to outperform the major market indexes to attract more investors and generate more fee revenues.
A possible risk of index trackers is over-diversification and duplication. For example, an investment portfolio consisting of several ETFs and index mutual funds may end up holding many of the same stocks. Conversely, stock picking could suffer from too little diversification. For example, a portfolio with only a handful of stocks could suffer severe losses if one or two of the underlying companies run into financial trouble. Investors could combine index tracking and stock picking to get the best of both strategies. For example, they could buy shares in a handful of companies they know very well and achieve sector and geographic diversification by buying index funds and ETFs.
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