One of the biggest developments in the fund industry has been the massive migration of assets from actively managed funds to passively managed index funds.
Despite this trend, the vast majority of mutual fund assets still remain in actively managed products, with 75% of equity mutual fund assets in active funds as of the end of 2016. Why are investors redirecting their investments? Index funds are often cheaper, and active funds, in general, have largely failed to beat their benchmarks over time.
In case if you are wondering whether mutual funds are right for you at all, you should read why mutual funds, in general, should be a part of your portfolio.
Actively Managed Funds Have Historically Failed to Deliver
Investors are often sold on the notion that a good professional money manager can beat the markets over time through skillful analysis and research. Unfortunately, that’s rarely been the case. The recent SPIVA U.S. Scorecard issued by S&P Dow Jones Indices emphasizes that point. For the five-year period ending in 2016, 88% of large-cap managers, 90% of mid-cap managers and 97% of small-cap managers underperformed their respective benchmarks.
A big reason for this is fees. In 2016, the average expense ratio for an actively managed stock fund was 0.82%. An index equity fund, on average, charged just 0.09%. Active fund managers would have to outperform their index by over 70 basis points per year just to keep pace post-expenses. Accomplishing that in any given year is a reasonable expectation, but doing so consistently over a period of five years or longer is incredibly difficult.
Check out this article to learn about why investors are fleeing actively managed funds.
Another reason is that many managers focus on a specific style or sector. These areas of the market tend to go in and out of favor over time. It’s one of the reasons that companies advertise these funds as long-term investments, to give shareholders time to ride out the highs and lows. Even the best value managers would have had trouble keeping up with the S&P 500 over the past few years, since their style has been out of favor for so long.
Why Are Investors Continuing to Go for Active Funds?
Despite the fact that investors continue to pull billions of dollars out of actively managed funds each month, they still account for roughly three-quarters of total mutual fund assets. If active funds are so prone to underperformance, why do investors still flock to them?
For many, choosing the best investment is a confusing process. Many look at historical performance figures for guidance, and simply choose the fund with the highest past returns, thinking that may guide them to the “best” product. Fund companies often take advantage of this and advertise the funds with the best returns or highest ratings, which, often times, are actively managed funds. These marketing efforts often instill a degree of confidence in investors, even though it may lead to underperformance in the future.
Another reason is that financial advisors are often compensated based on the products they sell, not necessarily the portfolio returns of their clients. Commissions for selling an actively managed fund are, in most cases, higher than those for selling an index fund.
Active Funds Can Still Make Some Sense
Given the woeful performance of active funds in keeping pace with their benchmarks, it’s worth wondering if there’s no longer a place for these funds in your portfolio. But there are actually a few instances where they still make sense.
If there’s one criticism of index funds, it’s that they’re relatively inflexible. They’re designed to give investors exposure to specific sectors or markets, but not necessarily to adjust due to economic conditions. Active managers who feel that an economic downturn is coming may position their funds more conservatively to try to limit potential losses. Index funds would not make such adjustments, and would remain fully invested regardless of market conditions.
Segments of the market that may require specialized knowledge, such as foreign markets or small caps, could benefit from active management. Areas that pose additional risks to investors could take advantage of the skill and knowledge of a manager.
Check out this article to learn more about some of the myths surrounding active fund management.
The Bottom Line
The trend towards index funds and away from active funds is unmistakable. In fact, analysts expect that index fund assets will surpass active fund assets by 2024. Investors aren’t able to control the performance of their funds, but they are able to control how much they pay for them. The difference in fees between passive and active funds is large enough that it rarely makes sense for investors to go the active route any more.
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