By Jeff Brown | Contributor
April 14, 2016, at 9:00 a.m.
It’s like yin and yang, animals versus plants, name brand versus generic. It’s the long-running struggle between actively managed mutual funds and the hot thing of recent years: passive, or index-style funds.
For many investors, academics and wealth advisers, the jury is in and index investing has won, thanks to low fees that allow indexers to beat comparable managed funds most of the time.
A year-end study by S&P Dow Jones Indices found that “over the 10-year investment horizon, 82.14 percent of large-cap managers, 87.61 percent of mid-cap managers, and 88.42 percent of small-cap managers failed to outperform (their index benchmarks) on a relative basis.”
Appeal for the human touch. But most investment dollars remain in managed funds, so what is their appeal?
Many observers say managed funds survive through salesmanship. Because their higher fees produce bigger profits for fund companies, the firms keep pitching them, these critics say. But some experts believe active funds do have an edge in certain sectors, and that a stellar manager can beat the indexes even if the average manager cannot.
“Indexing is perfect for large-company stocks traded in highly efficient markets in the U.S., Europe and Japan,” says Paul Jacobs, chief investment officer of Palisades Hudson Financial Group in Atlanta. “Actively managed funds are the way to go with small companies, emerging markets and REITs (real estate investment trusts), where the manager can profit from inefficiencies.” His typical client has 60 percent of holdings in index funds, 40 percent in managed funds.
The difference. The distinction between active and passive funds is fairly simple. Active funds employ analysts and managers to hunt for hot stocks and bonds. Index funds merely buy and hold the stocks or bonds in an underlying market gauge like the Standard & Poor’s 500 index or Dow Jones industrial average.
Last year, a Morningstar study found that “actively managed funds have generally underperformed their passive counterparts especially over longer time horizons, and experienced higher mortality rates – that is many were merged or closed.” Higher fees were the chief drag on active fund performance, Morningstar concluded, echoing many previous studies.
Over a 10-year period, active managers beat comparable index funds in only one of 12 categories, U.S. mid-value stock funds, Morningstar found. Among funds holding growth stocks in large U.S. companies, for instance, only 16.9 percent of active funds beat their passive counterparts over 10 years.
A growing trend. More than $2 trillion is invested in index funds, according to the Investment Company Institute, the fund industry’s trade group, and that has been increasing. Among stock funds, for instance, indexers account for more than 20 percent of investors’ holdings, up from 9.4 percent in 2000, the ICI says.
Still, those numbers show that millions of investors still trust in active managers with most of their money. And the appeal is not hard to understand. After all, we hire experts for our medical and legal needs, get pros to teach our children and fix our cars. Why not hire a money manager who focuses on these issues all day every day? And even if the average active manager cannot beat the indexers, can’t you still win by picking someone who’s better than average?
“Because of the Efficient Market Hypothesis, which states that prices reflect all available information, including forecasts of the current information on future prices, there are no areas where actively managed funds make sense,” says Mark Hebner, CEO of Index Fund Advisors, an Irvine, California, wealth advisory firm that favors index funds.
The reason so many investors favor active funds? “In short, it is because it is gambling, and gambling leads to various degrees of addictive behavior,” Hebner says.
But others say active funds can serve a purpose.
Role for a manager. Aaron Gilman, president of IFP Wealth Management in Tampa, Florida, says active funds are suitable for investors who worry about losses in a down market, since active managers can put cash on the sidelines or use other strategies to minimize losses, while index funds must continue to hold the same mix of assets no matter what.
“It makes sense to add in active management in pockets of the market where you need risk management, or do not want to hold everything in the index,” he says. Currently, he feels investors are wise to consider active funds holding small or micro-cap stocks and emerging and frontier market stocks, or which use long and short strategies or multi-cap world strategies.
Chad Carlson, owner of Balasa Dinverno Foltz, a wealth management firm in Chicago, says that for stock holdings, “an all-passive approach is a sound one.” But he believes the bond market has enough pricing inefficiencies that active managers can indeed find bargains.
He says about two-thirds of an investor’s bond holdings should be in actively managed funds.
Those who do see a role for active funds stress, however, the importance of picking carefully, focusing on those with low fees, good track records in both up and down markets and comparatively low turnover – the percentage of fund holdings bought and sold every year. Too much turnover can trigger annual tax bills, raise internal costs, and suggest the manager is grasping at straws.
“Choose only active funds that have both an excellent long-term record and reasonable fees,” Jacobs says.
Star power. For active management devotees, the allure of the star manager is hard to resist. The problem is how do you know which top-performing managers were smart, and which were just lucky? Among the thousands and thousands of fund managers, some are sure to put together a string of winning years through luck.
Unfortunately, fund companies don’t disclose details on every trade, so even an expert can’t tell for sure if a winning streak was luck or skill. And if you find a true superstar, he might lose his touch, quit, retire or die. With an index fund, you have none of those worries.
One alternative: use index funds for the bulk of your portfolio and try a few managed funds to act on your own theories about the market.