Active and passive portfolio management
A portfolio of securities can be managed in either a passive or an active way. Active portfolio management is a complicated process involving a lot of decision-making and usually a high level of risk. It requires comprehensive knowledge of security valuation and portfolio management principles. A passive portfolio management strategy, also called a buy and hold strategy, is chosen by investors who are skeptical that money managers can improve on the aggregate market performance without raising risk. Besides, passively managed portfolio’s fees are lower because of lower portfolio turnover.

Indexing - a passive portfolio management strategy
Some investors do not have time or enough investment knowledge to follow markets, do research, and make buy and sell decisions. Such investors can simply choose to replicate the performance of the aggregate market by indexing. Indexing provides investors with the market average return for a low fee.

An index fund is a passively managed mutual fund that mirrors as closely as possible the performance of a particular market index. An index is the number that represents the market or group of stocks and calculates its performance over time. An index fund invests in all the same securities and the same percentages of those securities that are included in the index.

For example, an index is composed of 20 largest market capitalization companies (market capitalization = stock price x number of shares outstanding) of a particular country. If an index is a market cap weighted type of index, all the 20 companies have assigned weights according to their market capitalization. If a company A’s market cap represents 18% of total market cap of 20 companies, the company A’s weight in the portfolio will be 18%. The portfolio is rebalanced periodically to reflect changes in the market.

Index funds may track very different indices. Some indices (the S&P 500 in the USA) are set up to measure the performance of large capitalization companies. Other indices may focus on smaller companies, international stocks, bonds, etc.

Which is better?
The basic differences between an index fund and an actively managed mutual fund are:

• an index fund tracks the performance of the market instead of trying to outperform the market;
• index funds tend to be much cheaper since there are no highly paid money managers to pick stocks and transaction costs are lower because of low turnover.

Numerous independent studies have shown that indexing provides greater returns than actively managed mutual funds over time with less risk and lower fees. More than half of active money managers underperform their benchmark indices. Since most active money managers are not able to beat the market, then investors should try to match the market at the lowest cost.

Advantages of indexing
Some of the advantages of index funds are:

• diversification (investor's money is spread over the entire market);
• liquidity (investor can redeem his or her shares at any time);
• efficiency (lower transaction costs and lower fees);
• convenience (participation in growth potential of many stocks with one investment).

Diversification and liquidity are very important for emerging markets in developing countries. 0ne can easily diversify his or her investment in developed countries and have liquidity but it’s almost impossible to do it in the emerging market. The lack of information, general illiquidity of the stocks can be avoided by investing in the index fund.

In the Lithuanian stock market the bid-ask spread can be as much as 10% for some stocks and then there are fixed price limits set by the Stock Exchange. Investing through an index fund one saves the bid-ask spread which one would have to pay if he or she would buy individual stocks by himself/herself.

Core investment
Some people do have an idea what a good company is (maybe they are working for it) and which company can do well in the future. However, this is not a complete investment program for long-term planning. Perhaps the best way to invest is to buy your favorites that may do well but also have a core investment that represents good allocation of equities for a long period of time and represents participation in the economy and the future of the country.

The use of index funds may be easier and less costly in terms of research and commissions, and it may provide the same or better performance than what is available from specific security selection.