Indexing vs. active management

A question from Yahoo! Answers:

Do index funds really work better than an actively managed portfolio?

Not exactly. They work better than the MAJORITY of actively managed portfolios that ONLY contain the index’s member stocks IN THE LONG RUN.

There are a few managers who seem to consistently outperform the market through security selection or market timing (some charge fees that exceed their outperformance, so they only outperform on before-fees basis, but not on after-fees basis). There are also managers who can enhance returns by investing in securities that are not included in the benchmark index (this is called “investing outside the benchmark”).

One of the simplest and best known ways to enhance the performance of an index portfolio is the so-called “buy-and-write strategy”: you continue to hold your index portfolio, but also write a not-too-far-out-of-the-money call option on it and invest the proceeds in the same index you are holding.

Another is “portable alpha”; instead of buying the index, you buy futures on it and invest the remaining cash in high-grade commercial paper and soon-to-mature Treasuries and high-grade corporate bonds while simultaneously short-selling Treasury bill futures. The resulting portfolio returns whatever the stock index returns plus the yield spread between the bond portfolio and Treasury bills minus commissions and fees.

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