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Why Invest in Actively Managed Mutual Funds?

During the past decade, investors in U.S. equities piled $1.4 trillion into index mutual funds and exchange-traded funds (ETFs)—while pulling $1.1 trillion out of their actively managed counterparts.1 To conclude from those numbers that actively managed funds may soon go the way of the dinosaur, however, would be a mistake, says Jim Peterson, chief investment officer of Charles Schwab Investment Advisory.

Although index funds represent almost a third of the U.S. equities market, up from a fifth just a decade ago,2 Jim believes that active management still has an important role to play—in three key areas.

1. Downside risk

Aiming to protect your downside is perhaps the single biggest reason to invest at least a portion of your portfolio in an actively managed fund. “Many active managers select stocks based on fundamentals—such as earnings per share—that at least theoretically reflect a company’s intrinsic value, whatever the market may be doing,” Jim says. Most index funds, on the other hand, are designed to mimic the performance of market-capitalization-weighted indexes like the S&P 500®, whose momentum is often dictated by just a few big stocks (see Can the Advance-Decline Line Predict a Market Top?).

This focus on fundamentals can hurt active managers in a bull market, when rapidly appreciating stocks rack up exponentially greater gains. However, it can help when the tide turns and stocks that once lifted the market now drag it down. Indeed, a majority of actively managed U.S. large-cap mutual funds outperformed the S&P 500 in 2007, when the stock market began to slide amid the first signs of the financial crisis, and again in 2009, in the midst of the Great Recession (see “When the going gets tough …” below).

2. Bonds

Perhaps the strongest statistical case for active management comes from the world of fixed income, where a majority of actively managed short- and intermediate-term investment-grade bond funds and global-income funds have beaten their indexes over the past five years.3 The reason for this outperformance lies in active managers’ ability to maneuver in an environment of rising rates.

Index funds must mirror their benchmarks’ holdings, regardless of what interest rates are doing. Funds that track the Bloomberg Barclays U.S. Aggregate Bond Index, for instance, have roughly 60% of their holdings in bonds with maturities of five years or longer4—a recipe for underperformance should interest rates continue to rise (see Whats in Your Total Bond Fund?). Active managers, on the other hand, “can swap out longer-duration bonds with shorter-duration ones in order to take advantage of higher rates sooner,” Jim says.

3. International

Nowadays, there’s almost no corner of the globe that international investors can’t access; however, knowing which corners hold the most promise and which the most peril is not for the uninitiated.

“Assessing potential investments across the planet is a lot to ask of an individual investor,” Jim says. What’s more, when it comes to investing overseas, complicating factors like currency fluctuations can test the limits of even the most talented individual.

In other words, there are more areas in which the average investor might want a professional’s opinion. And that’s precisely what active management has to offer.

1Investment Company Institute. Data from 01/2007 through 12/2016.

2Morningstar, as of 01/31/2017.

3S&P Global. Data from 01/01/2012 through 12/31/2016.

4Bloomberg L.P., as of 12/20/2017.

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Important Disclosures

Investors should consider carefully information contained in the prospectus or, if available, the summary prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by calling 800-435-4000. Please read the prospectus carefully before investing.

Past performance is no guarantee of future results.

Investing involves risks, including loss of principal.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers are obtained from what are considered reliable sources. However, their accuracy, completeness and reliability cannot be guaranteed.

Charles Schwab Investment Advisory, Inc., is a registered investment advisor and an affiliate of Charles Schwab & Co., Inc.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks, including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors.

International investments involve additional risks, including differences in financial accounting standards, currency fluctuations, geopolitical risk, foreign taxes and regulations, and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The S&P 500 Index is a market-capitalization-weighted index comprising 500 widely traded stocks chosen for market size, liquidity and industry-group representation.

The Bloomberg Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, U.S. dollar-denominated, fixed-rate taxable bond market.


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