DEFINITION of 'Active Index Fund'

An active index fund is a basket of assets which the fund manager constructs the initial investment with holdings from a benchmark index and then adds securities unrelated to the underlying index that can drive performance higher. This additional layer of non-benchmark securities aims to boost returns above a traditional buy and hold passive strategy. By adding individual stocks disconnected from the broader index, the fund manager can unlock additional alpha. 

BREAKING DOWN 'Active Index Fund'

An active index fund attempts to take a version of an index fund like the Standard & Poor's 500 Index (S&P 500) and periodically rebalance all the stocks to match the proportions found in the actual S&P 500. The manager will add stocks to the fund they believe will yield additional returns to the passive index fund. For example, if the manager believes semiconductors will produce strong results for future quarters; more semiconductor stocks would be added to the portfolio.

While it is possible for some fund managers to significantly beat the underlying benchmark index by using strategies like market timing, this is far from guaranteed. Passive funds can be counted on to follow an index faithfully, which allows investors to know the true holdings and risk profile of the fund. This helps investors keep a diversified portfolio and managed expectations.

Adding an active layer to the index fund makes it difficult for the investing community to anticipate the future makeup of the fund. This can work for investors when the market experiences heavy volatility and the fund requires a trained professional to limit drawdowns. A fund manager can shift allocations away from underperforming positions to more appropriate sectors or asset classes. However, most empirical research finds a simple passive strategy tends to outperform a complicated active management approach.

Limitations of an Active Index Fund

Although an active index fund holds many of the same securities of a traditional index fund, they tend to come at a premium. Taking an active management style means the fund must charge higher fees to cover the cost of the manager, research materials and any other data required to make thoughtful investment decisions.

These higher expense ratios put pressure on fund managers to consistently outperform or beat the underlying index. As with a mutual fund, the potential to outperform comes down to the manager. Some have a knack for finding hidden gems, but most will pick losing assets that limit potential performance of the fund.

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