Which are better—actively managed funds whose managers pick which stocks to buy and sell…or a passive investment such as an index fund? The debate has been raging for years. Over the past 10 years, fewer than one in five actively managed large-cap stock funds outperformed its benchmark index…and only about one in 10 mid-cap and small-cap funds did so, according to a report by S&P Dow Jones Indices. But as of early March 2015, the tide seemed to have turned, with more than half of active managers outperforming their benchmarks. And of course, if you want any chance of beating the market, index funds are never going to do that.
Top financial adviser Grant Rawdin says the best approach is to use both active and passive funds in your portfolio. Mixing the two as part of a well-thought-out plan can provide long-term investors with a strong opportunity to beat the market, a less volatile ride and more peace of mind. Bottom Line/Personal asked Rawdin how he combines these two contrasting strategies and why the approach could be especially effective in 2015 and beyond…
When I started as an adviser nearly 30 years ago, I used actively managed funds exclusively. At the time, there were just a handful of index funds available, and it seemed as though any fund that had to own every company in an index, good and bad, was no match for a smart manager who could be far more selective.
But in the past decade, the number of index funds and exchange-traded funds (ETFs) that track indexes has soared—there now are more than 1,300 with a total of nearly $1.5 trillion in assets.
Actively managed funds typically charge much higher fees than index funds, and they buy and sell stocks more frequently, which often means a bigger tax bite for investors. Actively managed funds that do beat their benchmarks often attract so much money that the managers end up putting those swollen assets to work by adding investments that are not their favorites.
Actively managed funds can face an especially big challenge in a powerful bull market, such as the one that has propelled the stock market over the past several years. Passive funds have an advantage during such periods because they tend to be nearly 100% invested all the time, while actively managed funds often have more assets in cash when they are having trouble finding stocks at reasonable prices.
Despite these “headwinds” against actively managed funds, I have never given up on them, especially now that I expect the market to face greater challenges and setbacks in the next few years. Here’s why: In the last two bear markets, a little less than half of large-cap fund managers beat the Standard & Poor’s 500 stock index. That doesn’t sound like great odds. However, with wise fund selection, you can choose managers who have a good chance of doing very well in down markets. Active managers tend to do their best in volatile conditions because they have the ability to steer clear of weak companies and trim positions in strong ones as valuations rise. If there’s a bubble in a particular area of the market, such as technology stocks in 2000, or if economic events hurt a particular sector, such as real estate stocks in 2009, active managers have many ways to curb losses, including shifting some assets to the safety of cash.
Using actively managed and passive funds allows me to draw on the advantages of both at a time when the direction of the stock market seems particularly uncertain. On the one hand, the strength of the US economy means that the bull market could continue, which tends to benefit my passive funds. But if rising interest rates undermine markets, as is very possible now, my actively managed funds can take advantage of corrections to scoop up the most attractively valued stocks. Historically, in the years in which interest rates moved higher, the average active large-cap manager outperformed the S&P 500 by 1.5 percentage points.
To gain the benefits of combining active and passive funds, you need to be disciplined in designing your portfolio. My advice…
Mix passive and active funds in each of the major asset classes in your stock portfolio. How many asset classes you use will depend on the size of your portfolio, the amount of diversification you want and the level of complexity you can handle. At the very least, you want exposure to US large-cap stocks…US small-cap stocks…foreign stocks…and emerging-market stocks. That means a basic portfolio would consist of a total of eight funds, including four active and four passive.
Within each asset class, divide your money equally between active and passive investments. Rebalance annually. Resist the urge to overweight your active or passive allocations even if one strategy is outperforming in the short term. It’s very risky to attempt to time shifts in the market that allow one approach to prevail over the other.
You can use more than one active fund within an asset class as long as each has a very different investment style. This extra diversification allows me to benefit if a particular style, such as value or growth investing, happens to be producing superior returns in any given year. For example, in the large-cap, actively managed portion of my portfolio, I divide assets equally between several funds including Dodge & Cox Stock Fund (DODGX), a value fund, and William Blair Large Cap Growth Fund (LCGNX).
For the passive portion of my investment portfolio, I own index funds that typically hold hundreds of stocks within their particular asset classes and have annual expense ratios below 0.5%. Consider passive funds from Dimensional Fund Advisors, Fidelity, iShares and Vanguard.
For the active portion of my portfolio, I look for great stock pickers. I also look for fairly concentrated portfolios of fewer than 100 stocks. I want managers who use a disciplined strategy even if it means being out of sync with the rest of the market. I generally prefer that the funds have both lower volatility and better performance than their benchmark indexes and most of their peers. I also prefer expense ratios that are much lower than the average among competitors in their asset classes.
Actively managed funds that I use, all of which are available to small investors…
Large-cap stocks: Dodge & Cox Stock (DODGX)…Hotchkis & Wiley Large Cap Value (HWLRX)…Janus Fund (JANSX)…William Blair Large Cap Growth (LCGNX).
Small-cap stocks: Baron Small Cap (BSCFX)…Royce Opportunity (ROFRX)…William Blair Small Cap Growth (WBSNX).
Foreign stocks: First Eagle Global (SGENX)…Janus Overseas (JDIRX)…William Blair International Growth (WBIGX)…Morgan Stanley Institutional International Equity (MSQLX).
Emerging markets: Morgan Stanley Institutional Emerging Markets (MSELX).
