Just the facts…
This has been the raging debate for decades: Should one use actively managed funds or passive 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. 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…
Yes, it is true that I spent more than 9 years as an active management junkie. I bought into the idea that a fund manager 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 managers will not outperform their benchmark. I held out hope that the statistics were wrong. I began doing my own studies of actively managed fund returns (instead of believing my employer’s sales pitch) and discovered for myself what the Standard & Poor’s Indices 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 underperform. 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 manager. 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 managers 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 manager knows that underperforming their benchmark is viewed negatively. This erroneous 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 underperform in the good years, so long as you outperform 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 managed 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%. (Source: etfgps.com)
- Actively managed funds underperform – According to the SPIVA 2016 Mid-year study, during the one-year period, 84.62% of active Large-Cap funds underperformed the S&P 500, 87.89% of active Mid-Cap funds underperformed the S&P Mid-Cap 400, and 88.77% of active Small-Cap funds underperformed 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 for your trade to execute. 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.
Actively managed funds are the funds of choice for most national investment firms with large scale marketing campaigns (read: Edward Jones, Fidelity, etc.). These firms seek to enroll you in their thought process and the “group-think” mentality of “everybody’s doing it,” which sucks-in even the most savvy investors. It doesn’t have to be that way, though. You’re now educated and know that you don’t have to lose money en masse with the rest of the country. Chladek Wealth Management clients are currently performing better than the S&P 500 YTD. If you’d like more information regarding our time-tested, research-based strategy, check out this blog post – Chladek Wealth Management Investment Strategy: The Numbers Don’t Lie.
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John P. Chladek, MBA, CFP® is the President of Chladek Wealth Management, LLC, a fee-only financial planning and investment management firm specializing in helping families and couples who are not yet retired realize their financial goals. For more information, visit http://www.chladekwealth.com.