Active mutual-fund managers are enjoying a moment in the sunshine after a long period of darkness.
Consider that half of large-cap blend funds topped the S&P 500 Index
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over the six months through February, and 57% of large-growth funds beat the S&P 500 Growth Index, according to research from Leuthold Group, using data from investment researcher Morningstar. Meanwhile, active has also stood out among small-cap blend funds, where 52% beat the Russell 2000
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benchmark.
Still, an array of experts say investors and advisers who have embraced index funds should be wary of switching sides, despite active management’s current enticing call.
Investors favoring indexed products for the stock portion of their portfolio should keep in mind their good reasons for doing so, these experts say. The majority of mutual-fund managers routinely lag behind their benchmark stock indexes and the corresponding index funds and index-tracking exchange-traded funds they are paid to beat.
This performance gap, due largely to active management’s higher fees, is particularly evident over the multi-decade horizon that defines most individual investors’ experience.
Even Warren Buffett, a paragon of active investing, praises indexing and its patron saint, Vanguard Group founder John Bogle. “Both large and small investors should stick with low-cost index funds,” he advised in his latest annual letter to Berkshire Hathaway shareholders, published in late February.
Here are two points to consider about the recent optimism for active management, and why so many experts believe most investors should stick to indexing.
1. ‘Active’ has its moments. But they are just moments.
Active managers do rise to the challenge at times. The November 2016 election ushered in a rally in some sectors — for instance, small stocks — boosting hopes that independent-minded stock pickers could break from the Wall Street herd.
“We’re optimistic about active management,” says Andrew Folsom, investment analyst for the global manager research team at Wells Fargo Investment Institute. He cites the coming end to the Federal Reserve’s “easy money” approach that penalized active managers seeking to invest in higher-quality companies; widening dispersion in stock returns; and a new crop of market winners and losers as a result of Trump administration policies that appear to favor value-priced, economically cyclical businesses.
Moreover, he predicts, the influx of money into indexed investing will slow, giving active managers their best chance in years to compete: “The headwind that once was a fire hose will be a garden hose.”
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Actively managed U.S. stock funds had record net outflows of $263.8 billion in 2016, while $236.7 billion poured into U.S. stock-index funds, Morningstar reports. Since the end of 2013, assets of index funds and ETFs have swelled 50%, to $5.4 trillion from $3.6 trillion.
Leuthold Group also sees the tide turning for active management. The firm cites currently “favorable to active” market conditions, including small-cap stocks beating large-cap; value-stock strategies outdueling growth; and the 25 biggest stocks in the S&P 500 collectively lagging behind their 475 less-pricey peers.
“This all favors the active investor who doesn’t chase those megacap growth stocks,” says Scott Opsal, Leuthold’s director of research. “When that top-heavy group is winning, the index is winning. When the other 475 is winning, that’s where active managers tend to fish.”
Shifting to active management based on short-term performance isn’t a long-term plan.
Still, shifting to active management based on short-term performance isn’t a long-term plan. If investors change anything now, they should consider adjusting their portfolio allocation, not their investment strategy. If small-cap is attractive, for instance, they can add small-cap index funds.
The impact of this advice becomes clearer when active funds’ results are considered beyond a year or two. Morningstar’s semiannual “Active/Passive Barometer” study, for example, shows active management’s strength erodes over time. A case in point is the one-year period through June 2016, the most recent report available, where 46% of small-cap blend funds beat their indexed peers. Yet over a five-year span, 32% of small-cap funds outperformed, and 26% over 10 years.
Active’s long-term erosion is perhaps best explained by the unrelenting tug of war between growth stocks and value stocks. This struggle is reflected in an investment maxim known as Dunn’s Law, which states that when an asset class does well, an index fund in that asset class will outperform active managers. Conversely, when an asset class does poorly, the odds favor active managers to do better.
This occurs because, unlike an index fund, no manager adheres 100% to a particular style; a value manager, for instance, might own some growth stocks. “Some of the cyclicality in manager-success rates is driven by shifts in style leadership, from growth to value and between large- and small-caps as well,” says Ben Johnson, director of Morningstar’s global ETF research. “If any style is in favor, the purest expression of that style — an index fund — is going to be pretty tough to beat.”
“What the data says is that during times of strong returns for the market and times of weak return, it remains hard for active management to beat a benchmark,” says Todd Rosenbluth, director of ETF and mutual-fund research at research firm CFRA.
Mitch Tuchman, managing director at Rebalance IRA, which uses indexing to oversee retirement investments, observes: “How much extra do you really think you’re going to make with active management, versus how much you can lose if you’re wrong? It’s too much risk, not enough possible return — and likely, less return.”
Indexing isn’t for all investors, of course, but it has changed their playing field. The popularity of inexpensive mutual funds and ETFs that track benchmark indexes has compelled active managers to lower fees in many cases. That is important, because cheaper is better with fund investing. Lower-cost stock funds — index or not — typically post better results than their higher-cost counterparts.
“Over long periods of time, keeping costs as low as possible is probably the only winning strategy,” Morningstar’s Johnson says.
Indexing also brings peace of mind for many investors. The approach is straightforward: You will gain or lose whatever an index does. There is no crystal-ball guesswork to divine the best and brightest fund managers, and, accordingly, less reason for trading and worry.
2. If you’re ‘active,’ be smart.
Investors who still choose active management should always remember that not all active managers are equal. Steer clear of firms charging standard retail for index-like returns, and instead support firms with upper-tier performance year after year, backed by a clear investment philosophy and process.
Going light on the most popular (i.e., expensive) stocks, or avoiding them, is one way a manager shows divergence from the pack, especially in a bull market. Holding an above-average amount of cash in a portfolio is another. When stocks are rising, cash will drag on performance, but also can cushion a downturn and give a manager trading flexibility and a war chest to buy stocks at cheaper prices.
“Active managers like to look far and wide for the best deals,” Leuthold’s Opsal says. “As long as these conditions stay, with a broad, economically driven value market, then active could win because value should win.
“If you’ve got active funds, don’t pitch them out,” Opsal advises. “The cycle will turn. Active will have its day again.”
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