When Should You Choose Active Over Passive Mutual Funds?

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By Kate Stalter

These days, investors hear fewer financial advisers promise they have the stock-picking chops to "beat the market." With memories of 2008 still fresh in people's minds, many advisers, as well as individual investors, approach markets with a more prudent perspective. Increasingly, eking out the last penny of potential return is secondary to managing risk.

%VIRTUAL-WSSCourseInline-681%However, individual investors, particularly those who enjoy actively trading their own accounts, are all too familiar with various newsletters and stock-picking software programs that promise (or at least suggest) the potential for eye-popping and market-beating returns.

It's certainly true that some actively managed mutual funds (those in which managers select securities, rather than simply track an index) outperform their benchmarks for some period of time. However, using active funds' past performance is an unreliable way to predict future returns. That's a warning investors will find in the small print of every mutual fund prospectus, but many choose to ignore, despite numerous studies confirming that fact.

How Now, Dow?

For example, July research by S&P Dow Jones Indices found, among other things, that of funds in the top performance quartile in March 2012, only 3.8 percent were still outperforming their benchmark by the end of March 2014.

%VIRTUAL-pullquote-Perhaps surprisingly, even active fund managers acknowledge that indexing can coexist with active management.%Of course, retail investors aren't spending their leisure time poring over these studies, and they're often left guessing which investment vehicles are the best fit for their unique goals and risk tolerance. Perhaps surprisingly, even active fund managers acknowledge that indexing can coexist with active management.

David James, senior vice president and director of research at the James Advantage Funds in Xenia, Ohio, sees a role for exchange-traded funds, most of which simply track indexes, alongside funds such as his. The James funds include the categories of mid-cap, small-cap and micro-cap stock funds, as well as long-short and balanced funds. "I like the fact that investors have the ETFs. They do add a component for investors, and they are low cost, but they are not quite the end-all, be-all," he says.

Multiple Approaches

James points out that most index funds are weighted toward the largest stocks in their given benchmark. "As long as the largest stocks of any style are doing well, the ETFs should do well," Hames says. "However, most of the time, it's other kinds of factors that will be adding value to investors, so whether you are taking a value approach, or a profitability approach, or a momentum approach, that's where that active management, at least for right now, continues to have a lot more of the leadership."

Jack Firestone, president and principal of Firestone Capital Management in Coral Gables, Florida, shares the belief that investors don't have to choose between an all-active or all-indexed portfolio.
He considers markets to be mostly efficient, meaning existing information is incorporated into securities' prices. However, he says, "Our experience teaches us that markets are not totally efficient. From time to time, managers with a defined process, with a focused portfolio, can and do outperform the overall markets. So we use a combination of both active and passive."

Firestone cites an example of pairing an actively managed approach with an index fund. His firm uses the Vanguard Total Stock Market ETF (VTI), which tracks performance of the University of Chicago's Center for Research in Security Prices U.S. Total Market Index. Firestone particularly appreciates the ETF's low expense ratio of just 0.05 percent.

To take advantage of market inefficiencies, Firestone may pair a broad index fund with, for example, a fund focusing on large-cap stocks, such as the FMI Large Cap Fund (FMHX). At the end of the third quarter, this fund held just 25 stocks. That concentration, Firestone says, allows the fund manager to zero in on the best ideas without being distracted. "A lot of active managers have 150 or 200 stocks in their portfolio. We believe that a manager really can't have 100 best ideas," he says.

Going All One Way

But a large number of investment advisers adhere solely to indexing, viewing markets as completely efficient. Vern Sumnicht, CEO at Sumnicht & Associates, an Appleton, Wisconsin, wealth management firm, switched to an all-passive approach a decade ago after a thorough review of returns from actively managed portfolios. He was disappointed in the results, and his research convinced him that indexing was the way to go.

"Advisers think they can be better than the average, but I think 2008 shook up a lot of those guys out there," he says. "There have been hundreds of empirical studies looking at this question, and they all have come up with the answer, that the indexes outperform, at any given time, 70 percent of individual money managers," he says.

Sumnicht acknowledges that low expense ratios of index funds contribute to that higher return ratio. "The costs are minuscule, relative to professionally managed mutual funds," he says. That means an index fund doesn't have to generate as high of a return as an actively managed fund if it's to deliver a profit to an owner.