Actively managed funds are designed to allow much more latitude to the fund manager on how they invest. The possibilities of what the manager can invest in are typically very broad. The biggest drawback is that history informs us that very few active managers consistently outperform the broad market, writes Arjun Oza. – @Siliconeer #Siliconeer #investing #stockmarket #arjunoza

In my last column, I laid out the benefits of investing over a long period of time. This allows the magic of compound growth to work for you and dampens the effect of sharp swings in stock prices (volatility). A good way of investing in such a manner is to invest through a passive mutual fund or similar financial vehicle. To recap, these investments adhere to strict rules on how and where they can invest, such as well-known indices like the S&P 500; Russell 2000 or EuroStoxx 50 (50 prominent companies in Europe). These funds are characterized by low costs, high transparency (you know exactly what you’re investing in), low stock turnover (components of these indices stay pretty much the same year to year) and are typically tax advantaged since stocks are held for long periods and hence capital gains on their sale are usually at lower rates.

Alternatively, you can invest your money in a fund that is actively managed. Actively managed funds are designed to allow much more latitude to the fund manager on how they invest. The funds charter will may allow the fund to go “long” (invest with the expectation that the stock will go up) or “short” (profit if the stock falls in price). It may allow the manager to invest in options underlying the stock, thereby making a short-term call on the stock or market. It may allow the manager to invest in both the U.S. or in international markets. The possibilities of what the manager can invest in are typically very broad.

So, what are possible advantages of investing in one or several active funds? You may like the idea that the manager can switch investments quickly and consequently allow the manager to take advantage of opportunities across a wide circle of investing opportunities. Perhaps you would like the manager to keep a large percent of assets in a safe investment if they believe the stock market is overpriced and set for a big drop. Some funds take concentrated positions which means they invest in relatively few stocks. Concentration would result in outsized returns if the fund manager has done their homework well and selected great opportunities.

There are disadvantages to consider. Active funds tend to charge higher fees than passive funds and sometimes egregiously so. All things being equal, this means you get to keep less of your money. Many tend to trade their stocks frequently resulting in higher taxes since short-term gains are usually taxed at higher rates than long-term gains. The biggest drawback is that history informs us that very few active managers consistently outperform the broad market. They may have the occasional good or great year of relative out performance, but few have been able to do it over a decade or two. There are notable exceptions. Peter Lynch ran the Magellan Fund from Fidelity for over a decade, and even after Fidelity’s fees were deducted, he handily trounced the S&P 500. Leon Cooperman of the Omega fund has an impressive record for 15 years. Warren Buffett has done that for over 50 years!

Ask some basic questions before you decide to invest. Is the manager the same as the one who ran it well in the past or has he/she moved on and taken their skill with them? What is the long-term record of the fund?  What the tax consequences for you if they incur large short-term gains? And, make sure you understand what the net performance of the fund, after expenses, is when comparing to possible passive funds.

As with all investment decisions, do your homework before you do decide to invest in anything.  Remember, it’s your money and your future.

Past performance is not a guarantee of future results. The above article is for informational purposes only. Readers are advised to seek individual advice from a professional of their choice before investing.