Investors face a steep learning curve when it comes to putting together their own portfolio. A workplace 401(k) may be the first time they've ever given a second of thought to stocks and bonds and they're faced with a bewildering array of mutual funds from which to choose.
According to investing theory, asset class selection is nearly as important as the actual mutual funds themselves. That doesn't make choosing investments easy however, particularly for investors concerned with managing short-term risk.
At the outset, investors have to decide if they believe that a mutual fund manager can protect them from crashes and outperform the market. Actively managed funds are, in general, more expensive than index funds. The main reason for the price difference is the cost of the manager and other analysts that research investments for the fund.
Underpinning the choice of active versus passive investing is the complicated theory or philosophy of efficient markets. Are all investments in the market priced correctly or are there some inefficiencies in there that a savvy manager can find and exploit?
Index funds follow market indices. A good index fund should hew closely to the index it follows. If the index the fund mimics is the Standard & Poor's 500 and it's up by a certain number of points, your index should be as well. The basic theory of indexing is that over time, most managers aren't going to beat the market, or even pad the downside, so why pay more for underperformance?
"The lower you keep the cost, the lower the hurdle is that you have to stretch in terms of risk. If you keep your costs down you can afford to take less risk, because you don't need to incrementally get that much higher of a return just to break even," says Tyler Bartlett, Certified Financial Planner, financial adviser at Merriman Capital Management in Seattle, Wash.
Active mutual funds contain hand-picked investments based on the funds goals and objectives. They rely on the skill of managers to outperform their benchmarks.
"If the manager or team is doing what they set out to do we think that over time they should outperform the passively managed index," says Michael Masiello, president of Masiello and Associates in Rochester, N.Y.
"I'd rather go with a manager who is following a strategy and a discipline versus an unmanaged and unwieldy, bizarre public driving an index. Last I checked the public is the one who makes all of the investing mistakes, do I want to connect my investing strategy to them?" he says.
Managed funds do beat index funds in many – but not most -- cases. Finding the funds that will outperform this year rather than last year is where it gets tricky – because in most cases actively managed funds do worse than index funds, on the way up as well as on the way down.
Standard & Poor's releases a report twice a year, the Standard & Poor's Indices Versus Active Scorecard report. In 2008, the worst year for investors in recent history, indices outperformed active funds in eight out of nine domestic equity categories.
"The belief that bear markets favor active management is a myth," the year-end 2008 report concluded.
In 2008 the percent of active funds outperformed by benchmarks was hardly a landslide across all categories though.
For instance, 22 percent of large-cap value funds were beaten by indices in 2008 compared to 90 percent of large-cap growth funds that were outperformed.
Percent of active funds outperformed by benchmarks
|2008||2005 through 2010|
|Large cap growth||90||82|
|Large cap core||52||63|
|Large cap value||22||34.67|
|Mid cap growth||89||82.14|
|Mid cap core||62.3||82|
|Mid cap value||67.1||71.76|
|Small cap growth||95.5||72.68|
|Small cap core||82.5||60.21|
|Small cap value||72.6||51.81|
From the Standard & Poor's Indices Versus Active Funds Scorecard, year-end 2008 and 2010
Clearly investors benefit from actively managed funds but it does introduce another element of risk into the equation: picking the right fund manager. Otherwise, it would be easier and cheaper to go with the index.