Index vs. Actively Managed Funds: Either/Or... or Both?
In the world of mutual funds, a common debate centers around the merits and pitfalls of index versus actively managed funds. Ardent supporters can be found in both camps: some investors swear by indexing; others are strong proponents of active management. While both exhibit recognized strengths and weaknesses, perhaps people are asking the wrong question. It doesn't have to be one or the other; maybe the optimal answer is: both.
Index funds seek to track the performance of a particular market benchmark, or "index," as closely as possible. They do this by buying and holding all—or in some cases a representative sample—of the securities in the benchmark they track. Index funds tend to have lower expenses and are quite tax-efficient, in that they generally trade less frequently because their underlying benchmark rarely changes.
Actively managed funds, on the other hand, seek to outperform their benchmark and/or peer group. They strive to do this through a combination of research, market analysis and forecasting, employing the expertise of a portfolio manager or team of investment professionals. Fees are generally higher than index funds, to compensate the managers and cover administrative and transaction costs. While offering investors the potential to outperform the market or to gain downside protection; active management also comes with the potential for underperformance.
For investors who recognize the advantages of both actively managed and index funds, here are five ways to help determine how best to distribute them within a diversified portfolio.
Addressing Market Efficiency
Given the nature of efficient markets—that publicly available information is already embedded in the price of most securities—it's not easy to identify mispriced securities with the potential to outperform. Advocates of index funds often cite the fact that it's rare for an actively managed fund to beat the broad market over an extended period. While that's generally true, the case is less straightforward in the context of less-efficient market segments—say, frontier markets (pre-emerging) or small niches such as a single commodity or sector—where a skilled portfolio manager may be more able to uncover undiscovered nuggets not recognized by an index (which often comprises the largest or most readily available securities within its universe). In such less-efficient markets, stocks trade less frequently, and investors are often slower to react to new information as it becomes available.
On the other hand, for highly efficient, broad market exposure or for sectors comprising highly liquid stocks, index funds may often make good sense for some.
Retaining the Opportunity to Outperform the Market
Although index funds and exchange-traded funds tend to offer a low-cost, tax-efficient way to match broad market returns, for many, there's an emotional element to investing. And although investors are cautioned to overcome emotion, it's hard to deny. Many investors seek the self-satisfaction of selecting a fund or funds that actually do outperform the market. It's illogical, but to some of those who own only index funds, they believe they could be missing out on the opportunity—however slim—to hit it "really big." Allowing a small part of a diversified portfolio to be allocated to actively managed funds—even in efficient markets—may quench that thirst for opportunity.
One way to employ this strategy, for instance, might be to hold a broad index fund, such as an S&P 500 Index fund, for the bulk of a portfolio's large-cap domestic exposure, complementing it with a highly concentrated fund by a strong stock-picker or a fund focused on a specific investment thesis.
One thing that can certainly be said of index funds: they accurately reflect the sometimes gut-wrenching swings of the index or market they track. While volatility fluctuates over both short and long investing time horizons, it tends to make many investors uncomfortable at best. To help reduce volatility, actively managed funds that take a defensive stance may be worth a look—particularly when the alternative is exiting the market altogether to avoid extreme volatility (which then raises the additional difficulty of determining when to get back in). Such funds look to temper the effect of large market swings, seeking to lose less in down markets but, of course, coming with the corollary of rising less during market rallies.
Conversely, investors whose portfolios are heavily weighted in actively managed funds may reduce volatility by introducing index funds. In some cases, actively managed funds that are long-term winners—often the most likely to be retained in a portfolio year after year—have achieved long-term success through some significant ups and downs along the way, so index investing may modulate such swings.
Hedging Against Market Crosscurrents
Actively managed and index funds tend to perform somewhat differently at various points along the market cycle. Generally speaking, broad equity index funds tend to perform well during momentum-driven periods, such as the market rebound that began in 2009. But when momentum slows, active managers may have an advantage, as they can search for attractively priced securities or shift among sectors to those that might have more promise during a correction. And because, of course, the timing of those shifts is virtually impossible to predict, it's best to be positioned for the eventualities of fluid markets than to try to react to them.
As most investors are well aware, expenses matter; and even seemingly small expenses add up over time. Many actively managed funds charge 1% or more in annual expenses, whereas some index funds may be available for as little as 0.05% in annual fees. For investors who favor actively managed funds, adding index exposure to the mix can have a significant impact on overall portfolio costs. A thoughtfully allocated 50/50 split between indexing and active management, for instance, using the examples above, would result in overall annual portfolio fees of just a bit over 0.5% without sacrificing outperformance potential.
The Bottom Line
There are myriad reasons for investors to structure their portfolios as they do. While both index and actively managed funds may very well have a place in your portfolio, it's important to know what's driving your decisions and that they aren't made haphazardly. A larger issue, perhaps, relates to investor behavior. Too many investors fail to stay the course, selling funds when they underperform or jumping in after a manager has exhibited strong performance. Perhaps, then, a better question to contemplate, rather than active or passive, is do you have a sound long-term investment strategy and the discipline to stick with it?
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Investment value will fluctuate, and shares, when redeemed, may be worth more or less than their original cost.
Diversification strategies do not ensure a profit and do not protect against losses in declining markets.