Index Trackers vs. Picking Shares

A stock index like the Standard & Poor's 500 is a sample from the universe of stocks you can trade. You can find indexes based on company size, industries, geographic regions, high-dividend payers, fast-growing companies, undervalued firms and other characteristics. An index has a low turnover rate -- most of the same stocks remain on its list of holdings from year to year. Trackers, usually mutual funds or exchange-traded funds, simply buy and hold the stocks on the index and seek the same returns as those provided by the index they follow -- they are passive managers.

Index ETFs don’t charge much, usually 0.2 percent to 0.3 percent. Managed funds generally charge between 0.5 percent and 2.5 percent. An index fund is only as diversified as its index. One based on the Dow Jones Industrial Average index tracks only 30 stocks, while a popular Wilshire index tracks 5,000.

Stock-picking, or actively managed, mutual funds and exchange-traded funds offer professional managers who try to beat benchmark indexes. In return, the managers collect a fee based on the value of the assets under their watch. They can also tack on sales fees and other charges that most index funds don't have.

While any fund will give you a certain amount of diversification, some managers can fill stock-picking portfolios with shares that are not necessarily well-diversified as a whole. For example, they may cover only a few companies. Other managed funds may hold dozens or hundreds of stocks. Risk drops when a fund boosts its diversification, since each stock becomes a smaller piece of the pie and is less likely to affect overall performance.

A tax-efficient fund has a low turnover ratio, which represents the lesser of either purchases or sales divided by average monthly net assets. A low-turnover fund usually has a ratio in the 20 to 30 percent range, according to Morningstar. Exchange-trade index funds have a fixed number of shares and are tax-efficient because there is little portfolio turnover -- only a change to the index requires any buying and selling by an ETF manager.

Infrequent turnover translates into occasional capital gains, which usually qualify for the lower long-term capital gains rates, making ETF index funds tax-efficient. Index mutual funds are generally less efficient than ETFs because they must constantly buy and sell shares when investors enter or leave the fund -- this churning increases realized capital gains and losses. A stock-picking fund can be volatile and generate many transactions, with turnover ratios above 100 percent.

The book "A Random Walk Down Wall Street" by Princeton economist Burton Malkiel popularized the notion that you can't consistently outperform stock averages. Malkiel says investors do better with index funds than with actively managed ones, or with trying to pick their own stocks. According to the giant financial services firm Standard & Poor's, more than 85 percent of U.S. actively managed stock funds trailed the S&P 500 stock index in the three years ending June 30, 2012. The five-year figure is more than 75 percent, and the 10-year figure is more than 59 percent.

Not all investors subscribe to the "Random Walk" theory. You might invest in a stock-picking fund because you want to beat the averages, not just duplicate them. Tom Kerr, portfolio manager for the Rocky Peak Small Cap Value Fund, says on the Seeking Alpha website that index funds underperform the indexes because of fund fees and that managed funds give you a fighting chance to smoke the averages. Such debate explains why some investors hedge their bets by combining the two approaches, putting money in both index funds and actively managed ones.