Passive investment strategies have become popular for good reasons. Index mutual funds and exchange-traded funds (ETFs) that track market benchmarks offer broad market exposure and tend to be much cheaper to own than funds actively managed by an investment professional.
But too often, investors overlook the unique potential of some actively managed funds, perhaps out of concern they’ll be too costly or end up underperforming a passive alternative. At times, active managers’ flexibility and specialized approaches to security selection can be an advantage, particularly when markets are turbulent. In fact, it might make sense for a truly diversified portfolio to include an allocation to both types of strategies.
“By holding a mix of passive and actively managed funds, you can take advantage of the strengths of the different approaches,” says Jim Peterson, chief investment officer of Charles Schwab Investment Advisory (CSIA).
Here we’ll look at a few of the potential advantages of active fund management and consider some strategies for selecting such funds.
Qualities to consider
Responsiveness to risk. Active funds might appeal in particular to investors concerned about suffering big losses in downturns. Whereas index mutual funds and ETFs will slide just as far as their benchmarks during a bear market, active managers work hard to manage risk by seizing certain market opportunities or using other techniques.
If this sounds good to you, you could begin your search for funds by identifying those with long track records of shining in hard times, keeping in mind that this doesn’t guarantee future success and that you should also consider other factors.
Understanding of foreign markets. Index mutual funds can be a good way to gain exposure to U.S. blue chip stocks, but because big, familiar companies are followed by thousands of analysts and professional investors, it can be hard for an active manager to gain an edge. In foreign stock markets, however, the game changes. Fewer institutional investors follow overseas shares, so it may be easier for fund managers to spot undiscovered gems.
Including different types of bonds. Active managers of fixed income funds have the potential to outperform their index counterparts in bond markets. For example, an index fund tracking the Barclays U.S. Aggregate Bond index would likely be heavily weighted toward Treasuries and other bonds backed by the U.S. government. At a time when Treasuries offer puny yields, active managers may be able to deliver better results by shopping for other securities.
“Active managers can potentially enhance returns because they have more flexibility to allocate to sectors such as corporate bonds and foreign bonds based on which sectors they expect to perform best,” says Jim. However, it’s also important to remember that higher yields typically come with higher risks.
Strategies for picking active funds
So what principles should you use when searching for an actively managed fund? Consider the following:
Look beyond short-term results. When investors shop for active funds, many pick managers who have delivered impressive short-term returns. But this can be a mistake. In some cases, the funds excelled by taking big risks or focusing on narrow segments of the market that can quickly move out of favor.
Be reasonable about cost. Some investors focus only on funds with the very lowest fees. While it is smart to avoid unreasonably expensive funds, fees should not be the only consideration. Instead, investors should look at a variety of factors. The goal should be to find managers who follow consistent strategies that have outperformed while limiting losses in downturns. A fund with low fees and an erratic record may not be as good a choice as a competitor with consistent outperformance and a slightly higher expense ratio.
Seek standout strategies. Portfolios that resemble their benchmarks are not likely to outdo the market, so look for funds with distinctive approaches. For example, managers could identify bargain-valued stocks that aren’t included in the benchmark index or they might venture outside the fund’s asset class: For example, a fund dedicated to large-cap stocks may be allowed to have up to 20% of its holdings in other assets.
Beware of bloated funds. Consider the size of the portfolio and whether investors have been pouring into the fund—these may not be good signs. For example, the most appealing small-cap funds tend to have less than $1 billion in assets. To appreciate why, consider a small-cap fund that has $200 million in assets and delivers strong returns. Investors pour in, and assets climb to more than $2 billion. To absorb all the cash, the manager may have to hold a greater number of stocks, picking names that are not necessarily his or her favorites. All that can result in weaker returns. “When a fund suddenly increases in size, its historical performance may not be sustainable,” says Jim.
As with any type of investment, not all actively managed funds are the same. Some are costly, some aren’t, and strategies vary.
What matters is whether you think a particular fund pursues a strategy that fits with your goals at a price you can accept. And think about how different funds might work with the other assets in your portfolio. It helps to think holistically about your investments. Don’t treat actively managed funds as a special category. They’re just one more tool to consider including in your toolbox.
Need helping picking funds?
Investors can consult Schwab’s Mutual Fund OneSource Select List®, which includes CSIA’s top picks in each category. The goal of CSIA’s approach is to identify funds that it thinks are most likely to outperform their peers over the next one to three years.
Spotting outperformers can be difficult, because some funds have lucky streaks that can make managers look more skillful. But hot funds often turn cold. To pinpoint attractive choices, CSIA researchers use qualitative and quantitative selection criteria such as expenses, historical track record and assets under management to analyze funds, with the most favorably evaluated ones earning spots at the top of the list.