The most fundamental issue facing fund investors is also the subject of what might be the most hotly contested debate in the financial services industry: Are actively managed funds or passively managed funds the better option?
Actively managed funds are run by managers who choose the investments in the fund based on a stated set of criteria. Investors opt for actively managed funds because they hope the manager has picked funds that will grow more — or lose less value — than the market in general.
Passively managed funds are also known as index funds because their portfolios mirror the components of a specific market index — for example, the S&P 500. These funds match the performance of the index they track.
Which is the better type of investment? That depends on each individual investor’s goals, risk profile, personality and attitude toward fees. There are good reasons to prefer index funds, but those who’d rather have active management can still pick the best funds available using a few criteria.
The case for index funds
Passive management has grown more popular in recent years, as most active managers fail to prove their mettle. In 2014, about 86% of large-cap equity managers underperformed their benchmark, or the index their performance is measured against, according to a report from S&P Dow Jones Indices. In other words, 86% of investors in a fund benchmarked to the S&P 500 would’ve done better to simply invest in a fund tracking the index.
This made 2014 one of the worst years ever for active management. But it’s not unusual for active funds to underperform. The same report found that over a 10-year period, more than 82% of large-cap managers underperformed their benchmark.
Even if your fund “beats” the market, it can still underperform due to costs. Active funds have much higher costs for trading and research, so their expense ratios are higher — usually 0.65% to 1%, as opposed to less than 0.20% for many index funds. The least expensive index funds charge as little as 0.05%.
The higher fees charged by active funds have a big impact on net returns, or what investors are left with after fees and expenses are deducted from a fund’s market returns.
Investors who don’t have the time or knowledge to research active funds should use index funds instead. This eliminates the risk of choosing funds that underperform the market.
What to look for in active funds
Despite all the benefits of passive funds, I’ve always been one to think that if everyone is doing one thing, then maybe there’s some benefit to doing the opposite. And new research on active funds has identified several key attributes of successful active funds — those that beat their benchmarks.
Low costs. Morningstar found that over a 10-year period ending December 2014, funds in the lowest quartile for fees had much more success beating their benchmarks than funds in the highest fee quartile.
High manager ownership. Capital Group found that mutual fund managers who invest along with their shareholders had success rates from 50% to 75% in beating benchmarks, compared with a success rate of about 25% for all active funds. If a fund has both low costs and high manager ownership, its success rate increases to about 90%.
Low turnover rate. Oppenheimer released a paper showing that funds with low investment turnover on average have historically outperformed their benchmarks. Turnover is a measure of how frequently a manager buys and sells the securities in the fund.
Investors should consider all of these factors when choosing funds. And after making a selection, they should review it regularly to determine whether the fund or their philosophy has changed and whether they need to make an adjustment. For example, a fund manager might leave an actively managed fund, leading to a strategy change.
In evaluating all mutual funds, you should be agnostic — skeptical, but open to proof of merit. In some situations, good passive funds might be best, but in others, solid active funds might be a better choice.