Credit: Shutterstock photoSpecial Report:Mutual Fund Strategies
T he active vs. passive debate is as ancient as the hills in mutual fund investing circles. And perhaps it's time to lead it gently to its grave. "The premise is misleading," said Ben Johnson, a Morningstar director of manager research. "We continue to frame the debate in analog terms rather than the digital reality."
In other words, both investing styles can happily co-exist within a successful mutual-fund investment strategy . An either/or approach is as old school as the cuckoo clock.
How do the two strategy types differ?
Investing in passive mutual funds is a tried-and-true method for success in the long term. You can ride the funds to a comfortable retirement.
That's true of actively managed funds, too. But for investors without the time, means or inclination to research active investment strategies , a passive fund is just fine. Think of it as your favorite set-it-and-forget-it kitchen appliance.
Passive funds track an index of stocks or bonds with a certain investing strategy in mind.
Their selling points include extremely low cost and very little tracking error.
Contributing regularly to a fund that tracks an index of diversified bonds or stocks, like the S&P 500, should get you to your goals.
Beating The Index
Actively managed mutual funds assume that you are trying to beat a boring old index. Fund managers try to find stocks likely to run up strongly in price. Finding them can involve studying charts, doing bottoms-up stock research, examining trends and timing the market.
Investors may assume more risk but for potentially much bigger gains. Fees are another difference. Active funds tend to cost more than their passive peers for two main reasons. The fund manager makes more trades to buy winners and sell losers, and that involves higher transaction costs. Plus, you're paying for his or her stock-picking expertise.
Other factors to look for with active funds are a proven track record, a sound investment process and manager tenure.
Mutual fund investors should consider both active and passive options, says Todd Rosenbluth, director of mutual-fund research at S&P Capital IQ. Understand the differences in cost and performance, he advises. Then decide how a particular product would fit your overall mutual fund investment strategy.
Investment experts suggest using passive funds for the core of your portfolio and active funds for the rest to juice performance. Depending on your risk tolerance, time horizon and financial acumen, you may want to devote 10%-40% to the actively managed portion.
"Investors taking on risk, which is what active is, can be rewarded," Rosenbluth said. But with too much risk in your portfolio, "you can be disappointed."
And there's the rub. It can be hard to tell when active risk is worth it and when it's not.
For core stock-market exposure, such as to U.S. large-cap stocks, index mutual funds generally can't be beat.
Large-cap core funds track one of the largest, most efficient markets. Just 23% of all large-cap actively managed funds outperformed the S&P 500 index in the three-year period that ended in 2014, according to S&P Dow Jones Indices.
Watch Expense Ratios
One of these funds is the $3.4 billion American Century Equity Growth Fund , which has outperformed both the S&P 500 and its category rivals in three of the last five years.
On the flip side, the $15 billion Davis New York Venture Fund has underperformed both its bogey and peers in four of the last five years.
The American Century and Davis New York funds charge 0.67% and 0.86% expense ratios, respectively, vs. 0.17% for the Vanguard 500 Index Fund .
Active managers have better odds in smaller and less efficient markets, says Johnson. Those areas may hold hidden or under-the-radar gems -- stocks and bonds that all investors have not yet accessed. International small caps, intermediate-term bonds and emerging markets are some such areas.
In these areas, active managers use their stock-picking skills to find winners outside the benchmarks.
"They win by fishing outside that pond," Johnson said.
Another advantage of active managers is their ability to react more nimbly to changing market conditions.
Bear Vs. Bull Market
This is true in both the equity and fixed-income worlds. Actively run bond funds can quickly adjust to rising interest rates by shortening duration or seeking higher yields.
And some active stock funds tend to do well in falling or bear markets. Large-cap value funds, on average, outperformed their benchmarks in 2000-2002 and 2008. Unlike a passive index-tracking fund that "sticks with the plan" even in a decline, cash positions help active managers limit losses.
In a rising or bull market, the opposite is true. Index mutual funds do especially well because they stay fully invested. They capture a lot of the move up.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
