Taking a Second Look at Actively Managed Funds

There may be a role in your portfolio for managers who use research, analysis and experience in making investment decisions.

For many investors, the debate between actively managed mutual funds and passive, or index funds appears to be settled: index investing has largely won, thanks to their lower fees that allow indexers to beat their managed fund counterparts most of the time.
Over a 10-year investment horizon, the majority of large-cap, mid-cap and small-cap fund managers failed to outperform their index benchmarks on a relative basis.¹

Percentage of fund managers who fail to outperform their benchmarks 

Source: S&P Dow Jones, SPIVA® U.S. Scorecard, Year-End 2015

One reason for this performance gap is cost. Owning an index fund is generally much cheaper than an actively managed fund, and in order to compete, an active manager must overcome the drag of higher fees by handily beating the index. The SPIVA Scorecard above illustrates that few managers can do this year after year.

Is there a role for active managers in your portfolio?

Despite the cost advantage of indexed investments, some active funds have an edge in certain sectors.² While indexing generally works better for large-company stocks traded in highly efficient markets, a number of skilled active managers may be more effective in less well-covered pockets of the markets, such as small-cap companies, emerging markets and real estate investment trusts (REITs). Of course, all mutual funds, whether they are indexed or actively managed, are subject to market risk, including the possible loss of the money you invest.

That said, research shows that not all active managers are equal in two key respects. Truly skilled fund managers identify companies that the broader market misses, potentially helping them outperform. Experienced managers may also have another edge: They may be able to help investors manage risk in down markets by moving a part of their portfolios into cash before the market turns, and put those funds back into the market when investment conditions improve.

For those reasons, you may want to consider combining active and passive strategies in your retirement plan. What characteristics should you look for in an actively managed fund? Here are several guidelines to keep in mind:

• Ignore short-term performance. As the old saying goes, investing isn’t a sprint, it’s a marathon. Short-term performance is often driven by reaction to economic or geopolitical events that have little to do with the long-term performance of the companies you own in your account.
• Make sure expenses are reasonable. It’s true that higher expenses in an underperforming fund can be a significant drag on your savings growth over time. But you shouldn’t necessarily ignore a great fund just because it charges more.
• Pay attention to risk-adjusted returns over the long term. Standard deviation (which looks at how returns are spread around their average) is generally considered a good way to measure how much an investment moves up or down over time. The higher the standard deviation, the more risky the fund.
• Seek managers who can clearly articulate a disciplined investment approach. Don’t invest in a fund you don’t understand, or in a fund that deviates significantly from its stated strategy.
• Pay attention to the culture of the management firm. Lots of staff turnover at an investment firm usually signifies a level of internal discord, which can negatively impact long-term performance. Re-evaluate your fund selections if there’s a manager change.

Investment styles fall in and out of favor. Although indexed-based approaches are currently hot and getting lots of media attention, some investors may wish to include some exposure to actively managed funds in certain asset classes—not only for their ability to control the risk of large losses, but also their potential to outpace the market.

¹ Source: SPIVA® U.S. Scorecard, S&P Dow Jones Indices, Year-End 2015. Past performance is no guarantee of future results.

² Jeff Brown, “Do Actively Managed Funds Really Pay Off for Investors?” U.S. News & World Report, April 14, 2016. 

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