Stan's World: Active vs. Passive Fund ManagementSubmitted by S. F. Ehrlich Associates, Inc. on March 31st, 2017
March 31, 2017
The ongoing debate between actively managed and passively managed mutual funds has picked up steam recently. Actively managed funds are mutual funds with an investment team that seeks to buy the ‘best’ stocks for their portfolio. I have an image of the chief investment officer standing on a desk in the middle of that fund’s trading floor screaming: “Buy only winners; sell all the losers. Your bonuses depend on it!” (Maybe I need to watch the movie Wall Street to see if they actually do that.)
Passively managed mutual funds follow an index, even if it comes with a slight twist. There are mutual funds, for example, that follow the S&P 500. They use sophisticated trading programs to ensure that the composition of their mutual fund generally follows the daily fluctuations of the S&P 500. Each day the program will dictate that they buy more of certain stocks while pruning positions in others. Presumably, there’s no yelling, and the people who write their trading software programs probably receive the biggest bonuses.
In recent years, active management has fallen out of favor, as many actively managed funds have failed to keep up with their passively managed brethren. It leads active managers to routinely declare that active management is better when markets go up, or active management is superior when markets go down. Or maybe they perform better when markets go sideways.
On more than a few occasions, I’ve been asked by clients if I know these winning managers or at least a few of their winning stocks. (I don’t know either.) I can only assume that some investors conclude that passive isn’t sexy (i.e., not enough ‘action’) and therefore can’t be the most profitable way to invest. To that, I say, au contraire.
Dan Solin, author of The Smartest series of books (e.g., “The Smartest Investment Book You’ll Ever Read,” etc.) notes that over the past five years, almost 92% of large-cap fund managers lagged the benchmark used to measure their fund’s success (or lack of same)1. As actively managed mutual funds also have higher fees than passively managed funds, the result is high fees generated poor performance.
More from Solin: While Vanguard’s index funds beat at least 61% of actively managed funds over the last 10-year period, the Dimensional Fund family performed even better. “On average, its funds outperformed 76% of actively managed funds over 10 years and 80% over 15 years.”1
The next time you think that passively managed funds are for sissies, think again. We invest in the equities and bond markets to be long-term winners, and if we can potentially do better by attempting to reduce the risk of hiring the wrong mutual fund manager (which apparently is most of them) by going after ‘average’ returns, then that’s a risk worth taking.
1 Solin, Dan. “The ‘Average Returns’ Myth.” Huffington Post, 17 Jan. 2017.