This has been the raging debate for decades. The debate is should you/we use actively manged funds or index funds (the vast majority of ETFs are index funds). Both sides have made fair arguments over the years but in the end most advisors and individual investors fall on one side of the fence or the other. The title of this blog kind of gives away which side of the fence we prefer. It was not always this way. It is no secret that I started out as a vehement active management guy but time has taught me valuable lessons. Read on to learn what changed my mind.
Realization
Yes, it is true that I spent more than 15 years as an active management junkie. I bought into the idea that a fund manger or team could do better than an index over the long-term. For too long I ignored the reality that the overwhelming majority of active fund manager will not outperform their benchmark. I held out hope that the statistics were wrong. I began doing my own studies of actively manged fund returns and discovered for myself what the Standard & Poor’s Indicies Versus Active Funds Scorecard (SPIVA) has been saying for years – active funds struggle to beat indexes.
The almighty benchmark
Active fund managers are judged on how well they do versus their respective benchmarks. Therefore, many fund managers attempt to mimic their benchmark to avoid the risk that they under perform. Sure there are fund managers that have great track records of beating benchmarks by either large or small amounts. The problem is in the bad years when the market is down -30% beating the benchmark by 5% and coming up with a – 25% loss is not something to be expected of a professional money manger. You have to ask yourself if paying high fees to actively managed funds that fail to beat benchmarks and don’t protect investors from losses is worth the price of admission.
If it seems like fund mangers lack the courage to move money out of the market you are right. There are very few fund managers that go to lengths to protect portfolios. Why? Because protecting a portfolio means giving up some of the upside and a fund manger knows that under performing their benchmark is viewed negatively. This wrong headed view of investment management is perpetuated by the financial services industry and the financial media’s lack of understanding of investing fundamentals. That is to say it is OK to under perform in the good years so long as you out perform in the bad years. Unfortunately, this basic math concept is lost in the desire to keep up with the benchmarks.
Still not convinced that actively managed funds are flawed?
The knock on Active Funds
- Higher Fees – Actively manged funds have higher fees. The average actively managed mutual fund has operating expenses of 1.43% where the average broad-based ETF has operating expenses of 0.18%.
- Actively managed funds under perform - According to the SPIVA 2008 study 71.9% of active Large-Cap funds under performed the S&P 500, 79.1% of active Mid-Cap funds under performed the S&P Mid-Cap 400, and 85.5% of active Small-Cap funds under performed the S&P Small-Cap 600 Index.
- Active funds drift - Today’s small-cap fund is tomorrow’s mid-cap fund and next year’s micro-cap fund. It is very common for fund managers to chase performance if it is not in the area they specialize in. This fact alone makes implementing an asset allocation strategy difficult with active funds.
- Active funds price once per day – If it is a really bad day in market with a mutual fund you must wait until close of business. It could be a long ride down with no escape hatch.
- Active funds are not very tax efficient – The unique structure of exchange-traded funds reduce the impact on the fund’s portfolio when shares of underlying securities are bought or sold. This, in turn, reduces the likelihood of the fund’s portfolio incurring taxable capital gains, which must be passed-through to shareholders.
- Mutual funds are not transparent – When you hold shares of a traditional, actively managed mutual fund you never know what is really in the portfolio as they are not required to disclose holdings daily like an ETF.