CHICAGO There’s a fine line between “the best way to invest” and “the best way for me to invest.”
Investors find that personal best by looking inward, but at the Morningstar Investor Conference here last week, money managers are arguing over what’s best. Their answers focus less on what’s best or what works for clients than about what’s best for them.
That’s at the heart of the debate that has dominated this year’s conference, the ongoing battle between active and passive managers, which has spawned questions here about whether the art of stock-picking is dead.
Active investments are those in which a manager runs the portfolio, typically attempting to beat some form of market benchmark over time, while passive investments generally are index funds, where the investor effectively buys the benchmark.
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Statistics, of course, may help answer what’s best, without answering what’s best for you.
Countless studies have shown that active managers generally fail to beat their benchmark, a tendency that is particularly true in rising markets, when it’s easier to make money through simply holding a growing asset, while an actively managed mutual fund has to hold some cash (which mutes returns), and overcome higher average expenses.
With the current bull market having run for more than six years now, plenty of investors and financial advisers have given up on active management.
Last Thursday, Morningstar released the latest data showing how hard it is for managers to beat index funds.
Morningstar’s “Active/Passive Barometer” measures the performance of active fund managers against the results of all index funds in the same Morningstar category, rather than against a singular benchmark. The problem is that indexes aren’t investable until they are used in funds; they don’t have expenses and more. Morningstar, therefore, compared large-cap growth funds that heretofore were measured only against a single index like the Standard & Poor’s 500 to the average of all passive funds tracking all of the various large-growth indexes.
According to the research, as of the end of 2014, actively managed funds lagged their passive counterparts across nearly all asset classes and Morningstar categories examined in the report, especially over the last decade. The only category in which active funds had a 10-year success rate above 50% – meaning their average manager beat the average index fund in the space – was U.S. mid-cap value.
It’s not some death knell for active management, however, because many of the people using passive investments are making active decisions.
That’s almost intentionally confusing, because that’s how the financial advisor community buffalos consumers. They chime out the numbers showing that passive funds work better, then put client money into those issues, and then make moves to run the portfolio, swapping in and out of those passive investments based on timing, intuition, management style and more.
In short, they add a layer of active management.
Thus, if the portfolio falls short, they might also be the problem (and it’s worth noting that their management fee for executing those strategies comes outside of the funds in the portfolio, which is how a consumer might see a portfolio of good funds but results that are nonetheless disappointing).
The superior performance numbers also don’t kill off active investing simply because of the casino or lottery-ticket mentality that many investors have when it comes to mutual funds.
Plenty of people believe that they don’t need for most active managers to beat the index, they just need to find the one or two guys that actually get the job done.
There’s also room in a portfolio for both strategies. The two sides here are less oil-and-water than oil-and-vinegar, capable of being mixed into something that investors not only stomach, but enjoy.
Judging from Morningstar data and a number of experts discussing the topic here, anyone looking to find those hallowed few who can get the job done should look for funds that have low fees (bottom 25 percent of their peer group), above-average performance, but with a track record that shows the fund does particularly well when the market is down, and managers who invest heavily along with shareholders.
Low turnover, high “active share” – a measure of the portion of return that varies because the fund is different from the index – and a management company willing to stop in-flows when a fund’s strategy might be diluted also are signs that there is a manager with high conviction that he/she can get things right.
Active management also survives because, for many people, that is where the “for me” comes to roost.
At the investor level, the active-passive question often has less to do with the funds than with the temperament of the buyer. If you can’t strap yourself into the market and ride it in all conditions, up and down, someone is going to have to do some active management to make sure you can live through market turmoil.
The rollercoaster is the best ride in the amusement park, but it’s not the best one for people who get queasy or suffer from motion sickness.
If buckling into the market makes an investor nervous enough that they might want to jump off mid-ride, then they need something that is more likely to allow them to stick to their plan and reach the destination.