Question Of The Month – February,  2010

What You Need to Know About ACTIVE VS.  

               PASSIVE Investing?

The active vs. index debate continues.  Actively managed stock mutual funds rebounded in 2009, ending slightly ahead of passively managed index funds. However, that small gain was barely enough to make up for their dismal showing in 2008. 

According to investment-research firm Morningstar, active U.S. stock funds were up an average 32.8% last year over all, compared with index funds' 31.7%.  However, during the market's brisk rebound from its March 2009 lows, index funds took the lead, surging 82% as active funds jumped 73%.

Over the past 15 years, about 60% of the mutual funds that invest in blue-chip stocks failed to beat the S%P 500 index (frequently cited as a proxy for “the market).  And that counts only the funds which performed well enough to survive those 15 years.  Many didn’t. 

Scott Burns, director of ETF research for Morningstar, says the decision to buy an index fund isn't "saying that you can't beat the market. It's just saying you don't know who will beat the market and that you'd rather keep costs low and have the average rather than risk picking a stud or a dud."

When you choose between actively managed and index funds, you need to keep five things to keep in mind. 

#1: A Good Run Will Not Last Forever.

Bill Thatcher, a senior consultant at research and consulting firm Hammond Associates in St. Louis, states that "Top-tier active managers with long-term benchmark outperformance almost inevitably have periods of three years or more where they underperform."

Some of the winners over the past decade lost big time in late 2008 and early 2009.

After beating the Standard & Poor's 500-stock index for 15 years, Bill Miller, Portfolio Manager of the Legg Mason Capital Management Value Fund, was down 55% for 2008, while the S&P 500 fell 37%. The fund ended 2009 up 41%, but lost more than 67% from the market peak in October 2007 through February 2009.

A $10,000 investment 15 years ago would be worth about $36,173 today. But anyone who jumped in with $10,000 around the peak of the market in October 2007 would have just $5,734.

John Bogle, founder of mutual-fund giant Vanguard Group and a champion of low-cost index funds says that "Yesterday's winners are far more likely to be tomorrow's losers.” 

Michael Mauboussin, chief investment strategist for Legg Mason Capital Management, says, "When you see streaks in investing, it's luck and skill combined." Bad luck played a role in the fund's 2008 performance, he says, just as skill played a role in its rebound last year.

#2: Expense Ratios Vary Widely.

Both types of funds have an “expense ratio” -- reflecting fees to pay for everything from administrative costs to the portfolio manager. It's expressed as an annual percentage of fund assets, and can range from under 0.1% for an open-end index fund to more than 2% for some actively managed funds.

According to Morningstar, on the whole, the expense ratios for actively managed funds are significantly higher than for index funds, with the average being 1.4% for the former and 0.9% for the latter. 

#3: Additional Fees Can Add Up.

Then there are transaction and trading costs. These are more likely to be higher for an actively managed fund, which typically does more trading than an index fund.  Dan Culloton, associate director of fund analysis at Morningstar states that they average about 1.4% or 1.6% on top of the published expense ratio. 

In addition, some funds charge a commission, called a "load," either when you initially invest in the fund or when you cash out your investment.

Thatcher adds "Actively managed funds' costs are higher than index funds' costs.  On the whole, active funds' higher costs do not buy you better performance."

#4:  Short-Term Gains Can Be Taxing.

Stephen Horan, head of professional education content and private wealth at CFA Institute, a nonprofit association of investment professionals says that actively managed funds trade more frequently, so many of the gains tend to be short term.  And short-term gains are taxed as ordinary income, with rates as high as 35%.

Horan adds that index funds, on the other hand, tend to buy and sell less frequently and more of their gains are long term, and, thus, subject to the lower capital-gains rate, a maximum 15%. 

#5:   If It Acts Like an Indexer...

Culloton adds that we should watch out for closet indexers -- actively managed funds that mimic an index -- especially if they are charging high fees.  If a fund is never too far ahead or behind its benchmark index and its correlation is really high with that index that could be a sign of a closet indexer.  Also, does a fund have hundreds of stocks in rather small positions or do its holdings look the same as the index but slightly rearranged, he asks.

Why are investors shooting themselves in the wallet? The expensive funds are pricier in part because they’re sold through financial advisers, a portion of whose compensation is built into the funds’ fees—and a lot of advisers saw their business tick up during the crash.  Some say that many investors are making a conscious decision to pay for advice. 

"If you find a fund that's got all of these traits and it's charging one percent or more, you have to ask yourself why."