Some mutual funds track an index by passively using algorithms to buy the shares necessary to build a portfolio which closely replicates an index. Such a fund will have low turnover, will only rebalance slightly based on the market cap or other criteria set forth in the prospectus, and will basically ride out all of the ups and downs of the index in a blind faith for the efficient market hypothesis.
This hypothesis states that you can’t outdo the market, because all of the self-serving, rational investors in the world will price in all known information day to day, and that the most efficient way to profit from the market is the buy and hold a broad index which captures all of the knowledge of the market makers and investors working together, essentially, to identify the best, most efficient companies.
Over the long haul, this may work, but there are plenty of impatient investors among us. Active fund managers seek to outperform the market by using the wealth of resources and research available to them.
Unfortunately their wealth of resources partially comes from a wealth of fees built into their funds. Still, plenty of active managers succeed in outdoing the indexes, if only for short amounts of time. If an investor is more interested in the short-term, this may be something he or she would like to be a part of.
Active managers will sometimes choose an index to base a fund on, and will acquire all the shares necessary to replicate the index, and then will also pick and choose what they believe to be winning strategies and stocks to invest in, as they attempt to out-do the index.
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