The Case for Actively Managed Mutual Funds

Oct 15, 2017 - 2:45 PM

In some quarters, the case against actively managed stock and bond funds seems settled. Warren Buffett, for example, has often flatly stated that they’re not your best bet, most recently in his 2016 year-end letter to Berkshire Hathaway shareholders.

“When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients,” he wrote. “Both large and small investors should stick with low-cost index funds.”

Although actively managed U.S. stock funds, with some $10.1 trillion under management, hold nearly twice as much money as mutual and exchange-traded funds (ETFs) whose portfolios simply mirror an index, investors have been heeding advice from folks like Buffett. Over the last three years, $600 billion has moved out of active management in U.S. equities, and $1.5 trillion has moved into passive management, Morningstar data shows. That’s a mark of how much mutual funds have evolved since Vanguard founder John C. “Jack” Bogle launched the first index fund, the Vanguard 500, in 1976.

“Gone are the days where you had active managers for all components of your portfolio,” says Heather Loomis Tighe, a managing director at BlackRock who heads its Institutional Endowments, Foundations, and Family Office business for the West Coast U.S. and western Canada. BlackRock sells both actively managed and index funds.

Passive management especially wins out in the U.S. stock market, notes Loomis Tighe, who adds that “for core U.S. exposure, we recommend ETFs.” For the 15-year period ended in December 2016, more than 90 percent of actively managed funds in all sectors of the equity market—focusing on large-, mid-, and small-cap stocks—failed to beat their benchmarks. The same was true for the past year and five years, she says.

The quirks of the bond market can make ETFs a good choice there as well. Many BlackRock clients choose fixed-income ETFs because putting together a bond portfolio on their own is expensive and time-consuming, Loomis Tighe says.

Where active management makes the most sense is with international stocks, for instance in Europe and Asia, says one analyst.

And as Buffett suggested, index funds cost less to own. Active funds charged an average expense ratio of 1.2 percent in 2016, while passive funds charged 0.66 percent, according to fund-research firm Morningstar.

“There is no more reliable predictor of future relative performance than fees,” says Ben Johnson, director of global ETF research at Morningstar. “That’s because, with low fees, a fund’s performance has a lower bar to clear before it turns into the black,” he says. A fund that charges 1 percent more in fees than another fund in the same category has to return 1 percent more before it can begin to justify its expense ratio, Johnson notes.

But there’s a place for active management, market analysts say, because in some sectors, managers have a shot at outperforming indexes. Where active management makes the most sense is with international stocks, for instance in Europe and Asia, Loomis Tighe says. Developing countries’ stock markets can also reward investors in actively managed funds.

“Overseas, active managers have more success because they can move away from troubled economies in emerging markets,” says David Snowball, publisher of the Mutual Fund Observer. One reason why is that emerging-market funds often have broad mandates that include many nations or regions, linked only by their developing-country status. If one country experiences a downturn, managers can pull money into other countries’ stocks.

Fixed income is another area where active management can pay off, Loomis Tighe says. Morningstar has found that managers of bond funds have better results than managers of stock funds. That’s because bond funds have different characteristics, like restrictions on the ownership of sub-investment-grade bonds, which certain funds can’t buy under their agreements with investors. When an issuer is downgraded, those funds may have to sell bonds that are now rated too low.

“Active managers who can invest in junk bonds can swoop in and buy them on the cheap,” Johnson says.

Absolute-value funds are one segment of the actively managed mutual fund spectrum where Snowball feels investors can get their money’s worth. These funds require managers to hold cash instead of stocks when their rubrics say that stocks are too expensive.

Adhering to an absolute-value plan takes patience. Managers can spend months or years waiting for the stock market to fall, in the hope of buying at the bottom. “After the market crashes, there’s this violent upturn that might last 12 to 18 months, and that’s where they make all their money,” Snowball says. One manager and his family voted to suspend Christmas in the depths of the global financial crisis, and instead spent “every penny they had” on undervalued stocks—a gamble that paid off when the market shot up after its 2009 low, Snowball says.

One problem with index funds and ETFs, Snowball cautions, is that they don’t hold cash or make decisions on which securities to own based on valuation; they simply replicate the benchmark. That’s good news when markets rise, but obviously not when they crash.

“You may find it difficult to sell ETFs in a downturn if they invest in illiquid securities,” Snowball says. “You have no downside protection.”