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Active Funds vs. Index Funds: What You Need to Know by James D. Peterson, Ph.D., Vice President, Investment Manager Research, Schwab Center for Financial Research and Justin Holt, CFA, Senior Research Analyst, Schwab Center for Financial Research July 8, 2009 Reprinted from the June 2009 issue of Schwab Investing Insights®, a monthly publication for Schwab clients. In 2008, many pundits wrote off actively managed mutual funds—those that try to beat their benchmark indexes—because they largely underperformed those indexes. But does that mean you should be invested in index funds—lower-cost funds designed to simply match the performance of their benchmarks—instead? Not necessarily. We advise against making the leap to an all-index-fund portfolio based solely on recent performance. Case in point: Investors who did so in late 2008 may now have some regrets—on the whole, active funds have outperformed their indexes during the first several months of 2009. No strategy outperforms in every market environment During momentum-driven markets1—when investors abandon fundamentals and chase hot stocks or sectors—index funds generally outperform their actively managed cousins. The reason? Unlike active funds, index funds hold most or all of the stocks in their benchmark indexes, most of which are capitalization-weighted (stocks with a higher overall market value have a greater influence on an index's performance). So investors chasing performance drive up these indexes, in turn boosting index funds. Witness the past two momentum markets: First, the Internet bubble of the late '90s, when active funds suffered by holding fewer tech stocks than their benchmark indexes; then, the liquidity crisis of 2007-2008, when anxious investors sold off everything but U.S. Treasuries. As all stocks plummeted, active funds underperformed index funds due to generally higher management fees. However, after a momentum-driven market has run its course, investing fundamentals usually return to favor, and actively managed funds typically regain the upper hand. The chart below illustrates the relative performance of an all-stock portfolio2 consisting of average-performing (within their categories) actively managed funds during and immediately following momentum-driven markets. Note that actively managed funds have rebounded after underperforming through most of 2007 and 2008. And with many high-quality stocks still near their 10-year lows, active managers who focus on these types of stocks may find yet more upside potential. Going forward, we see the market staying focused on fundamentals as long as investors see positive signs in the economy—though if the economy turns sharply up or down, we wouldn't be surprised to see momentum return to favor. Index vs. active: What's right for you? In addition to looking at relative performance and market expectations, consider the following to decide whether index funds or actively managed funds (or both) make sense for you. Consider index funds if:
Consider actively managed funds if:
Looking at the chart, the outperformance of active funds appears relatively small. That's because active management is a zero-sum game—lackluster performance by some managers offsets gains achieved by top managers. That's why fund selection is so important. For example, assume you held top-quartile funds during the first four months of 2009, rather than average-performing funds: You would have beaten the benchmark by 5.79%—better than 1.29% if you had invested in a portfolio of average funds.
If you have questions or need help, please contact your Schwab consultant. If you're not yet a Schwab client but would like to learn more, a Schwab consultant can help. Call 800-435-4000 to get started. 1. Momentum-driven markets are defined as periods when investors could have outperformed by investing in stocks that achieved the highest returns during the prior 12 months. 2. The all-stock portfolio consists of an allocation to the average monthly returns of the following Morningstar categories: 53% large blend, 21% small blend and 26% foreign large blend. Important Disclosures 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 800-435-4000. Please read the prospectus carefully before investing. Past performance is no guarantee of future results, and your investment value and return will fluctuate such that shares, when redeemed, may be worth more or less than original cost. See Schwab.com for more recent performance. Charles Schwab & Co., Inc., member SIPC, receives remuneration from fund companies participating in the Mutual Fund OneSource® service for recordkeeping and shareholder services and other administrative services. Schwab also may receive remuneration from transaction fee fund companies for certain administrative services. This report is for informational purposes only and is not an offer, solicitation or recommendation that any particular investor should purchase or sell any particular security or pursue a particular investment strategy. All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Past results are not indicative of future performance. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision. Past performance is no guarantee of future results. The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc. (0709-9089) Return to Top |
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