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When Actively Managed Mutual Funds Might Make Sense

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Key Points

  • Actively managed mutual funds can offer advantages to investors in certain asset classes and market conditions.
  • Potential benefits of actively managed funds include their ability to respond to risk, insights into less-efficient markets, and broadening bond exposure.
  • Actively managed mutual funds in combination with passive investments such as index funds or ETFs can broaden a portfolio's overall diversification and potentially limit losses during market downturns.

Passive investment strategies have become popular for good reason. Index mutual funds and exchange-traded funds (ETFs) that track market benchmarks typically offer broad market exposure at typically lower costs than funds that are actively managed by investment professionals.

But often, investors overlook the unique potential that some actively managed funds can offer, due to concerns of paying too much and/or the prospect of underperforming a passive alternative. At times, however, the flexibility and specialized approaches to security selection accessible to active managers can be an advantage, particularly when markets are turbulent.

To achieve diversification in your portfolio, it may make sense to combine both active and passive strategies. To determine when it might make sense to consider actively managed mutual funds over index funds, consider the following.

Responsiveness to risk: During market declines, index funds and ETFs will generally incur losses to a similar extent as their benchmark; active managers often have the flexibility to attempt to manage risk by seizing potential market opportunities or through other techniques, such as focusing on higher-quality stocks or trimming positions as valuations rise.

Something else to keep in mind: Limiting market losses can have big repercussions. Although actively managed funds don't all have the mandate to reduce downside risk, those that do might make it a bit easier to recover following a market downturn. After all, the bigger the loss, the more difficult it is to recover: A 5% loss requires a 5.26% gain to break even, but a 20% loss requires a 25% gain; and a 50% loss requires a whopping 100% gain to restore a portfolio to its previous value.

Insights into less-efficient markets: Index mutual funds and ETFs can be a good way to gain exposure to large, efficient asset classes, where publicly available information is already embedded into the price of most securities. In less-efficient market segments, however, such as frontier (pre-emerging) markets or small niches such as a single commodity or sector, a skilled manager can potentially uncover gems not included in the indices, which tend toward the largest companies in their respective investment universe.

Broadening bond exposure: In fixed income markets, active managers have the opportunity to stray from the crowd in search of market-beating yields. This is particularly true in relation to broad-based bond funds, whose indices are often heavily weighted toward U.S. Treasuries and other government-backed bonds. When yields on Treasuries are low (as they have been for some time), active managers have the flexibility to search for higher yields, for instance in the form of corporate or foreign bonds in sectors expected to perform well, or to hold fewer rate-sensitive bonds. Of course, it's important to remember that higher yields are typically accompanied by higher risks.

Strategies for Picking Active Funds

Due to the sheer number of actively managed funds available, finding appropriate ones can seem daunting. Here are some ideas to help streamline your search.

Look beyond short-term results. Media attention tends to go to funds with stellar short-term returns, so those funds may be top-of-mind. But short-term performance can be fleeting, often the result of taking big risks or making sector bets that can just as quickly fall out of favor. Instead, look for funds with long track records of index-beating performance, especially during down markets. The Mutual Fund OneSource Select List® is a good resource that identifies funds that Schwab believes are most likely to outperform their peers over the next one to three years. 

  • Be reasonable about cost. While fees are of course important, screening for the lowest fees can exclude some strong active candidates. Annual operating expenses should be one of multiple factors considered, with the goal of identifying fund managers who consistently adhere to strategies that have outperformed while limiting losses during downturns. In other words, a fund with low fees but an erratic performance record may be less optimal than one with consistent outperformance and slightly higher expenses. Low management fees and expense ratios are an important consideration for funds selected for the Mutual Fund OneSource Select List®.

    It's important to note that the fees for actively managed funds are often higher than index funds. However, many actively managed funds, along with index funds and ETFs, have significantly lowered their fees over the past 20 years. According to the Investment Company Institute, the average equity mutual fund expense ratio has fallen nearly 40% since 1996, from 1.04% to 0.63% in 2016.1

  • Seek standout strategies. Investors who are seeking returns in excess of index or benchmark returns, may want to consider funds with distinctive approaches. One measure of this is to review a fund's "alpha", which measures its performance on a risk-adjusted basis against its benchmark index. A positive alpha means that the fund has outperformed the benchmark. This can be found on the Research tab at schwab.com under "Risk & Tax Analysis" for a specific mutual fund. Another useful measure, on the same tab, is a fund's upside and downside capture ratios. These measures can help you evaluate a fund's past performance in up and down markets: An upside ratio of over 100 means a fund has outperformed its benchmark in up markets, whereas a downside ratio of under 100 shows that the fund has lost less than its benchmark in down markets.

Other considerations

Consider how different types of funds might work within the context of an overall portfolio. It helps to think holistically about your investments, and there may be a role for both active and passive management in your portfolio. 

Additionally, investors should consider their risk tolerance and personal financial conditions when investing in a mutual fund or ETF. Plus, don't forget about potential tax consequences: Active funds are more likely to distribute capital gains, which are taxable in non-retirement funds. Depending on your tax situation, it might make sense to hold active funds in tax-advantaged accounts such as IRAs or 401(k)s.

 Need Help Picking Funds?

The Mutual Fund OneSource Select List® is a good place to start. It identifies funds that Schwab believes are most likely to outperform their peers over the next one to three years, based on qualitative and quantitative criteria including expenses, tracking error, historical track record and assets under management. 


Investors should consider carefully information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling Schwab at 1-800-435-4000 or by visiting www.schwab.com. Please read the prospectus carefully before investing. 

Investment value will fluctuate and shares, when redeemed, may be worth more or less than original cost.