Passive index fund investing is popular for a singular reason. In most cases, passive index fund investment returns surpass those of active fund managers.
John Bogle and his Vanguard brokerage firm launched the first S&P 500 index fund in 1977 with the idea that if costs were slashed, a simple fund that mirrored the S&P 500 had a chance to return close to 9 percent annually, the historical stock market average.
Gradually, the index fund caught on and today there are hundreds of varieties of index funds covering popular indices such as the Dow Jones industrial average and the S&P 500, to niche funds encompassing small-cap, growth, value stocks and more. Investors can also choose from bond, commodity and alternative asset index funds.
[See: 8 Tips for Choosing an Active Fund Manager.]
The index fund mania doesn’t show signs of abating. A recent research report from Standard & Poor’s found that index fund investing was more successful than ever. The 2017 report states that over the last 15 years, 92 percent of actively managed large-cap funds returns lagged those of a S&P 500 index fund. And, small- and mid-cap active funds were worse performers with 93 and 95 percent of indexes, respectively, winning the return competition over similar actively managed funds.
The odds of beating an index fund with an actively managed one is roughly one in 20.
So why consider actively managed funds when indexing is a slam dunk?
Well, fund returns are averages, and during shorter time periods, with varying market conditions, there might be room for active management. Realistically, if all actively managed funds were terrible, they would cease to exist. And that hasn’t happened.
Many financial advisors and fund managers strive to add alpha with a combination of both passive and actively managed funds.
Another problem with index funds is the pain when the markets crash. Investors are in the heady bliss of a nine-year bull market. But do you remember the last market crash? An investment in an S&P 500 index fund would lose 36.5 percent if the market drops that same amount, as it did in 2008.
Don Schreiber, founder and CEO at WBI in Red Bank, New Jersey, recommends comparing returns over full cycles, not just during bull markets. “The problem with the passive indexing conclusion is not the eye-catching performance in up markets, but the massive losses incurred by investors in down markets,” he says.
Jack K. Riashi Jr., financial advisor at Bloom Asset Management in Detroit, lays out criteria for choosing an actively managed fund. These guidelines give a framework for analyzing an active manager, beyond return data, which can turn on a dime.
[See: 8 Do’s and Don’ts During Market Volatility.]
Riashi recommends considering the manager’s length of time at the helm along with the fund’s expense ratio. Lower expense ratios make it easier to outperform the indices. He advises examining rolling performance over five years or longer, to tap returns in various market cycles. Riashi prefers funds with managers invested in the fund so their financial interests align with those of the shareholders. Finally, an important point to consider when selecting an active fund manager is the fund’s tax efficiency. Here is where active management can outshine index funds that typically pay out annual capital gains.
Ultimately, there will always be active managers that outperform the index funds. Yet, it’s unusual for the same actively managed fund winner to regularly repeat. Larry Solomon, director of financial planning and investments at OptiFour Integrated Wealth Management in McLean, Virginia, recommends T. Rowe Price Capital Appreciation (ticker: PRWCX), a flexible allocation fund with a remarkable track record of beating the S&P 500 by approximately 1 percent annually over the last 10 years with only 75 percent of the index’s volatility.
Another actively managed fund, Catalyst Millburn Hedged Equity Strategy ( MBXIX) has had one negative year over the last 21, says Jerry Verseput, president and principal advisor at Veripax Wealth Management in Folsom, California. While it’s tough to beat the large-cap indices in this well-researched area, there might be room for excess returns in the more obscure and less-researched foreign small cap, energy infrastructure or other niche markets, Verseput says.
[See: 8 Cheap ETFs to Build Your Nest Egg.]
To set a hard and fast rule about investing in only index funds, could deprive your portfolio from the savvy skill, strategy or timing that an active fund manager might add. “Investors commonly frame the decision as a binary choice between an all-active or all-passive approach, but there will always be time periods when active management beats indexing and vice versa,” Solomon says.
So, don’t bury the active fund just yet. There’s still some life in this investment strategy.
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