Actively Managed or Index Funds?

This topic has been discussed many times in the past. In my last post in April 2009, I mentioned that despite the apparent lower costs, index funds remains unpopular among investors, accounting for only 12% of the total equity mutual fund assets as of 2007. There are many reasons that investors turn their back on cheap index funds and pour their money into actively manage funds instead. Among them, hoping for a performance that beats the average return is the main reason for people to favor actively managed funds over cheap index funds. By investing in actively managed mutual funds, investors effectively put the fate of their investments in the hands of fund managers who make all the decisions of what to buy and when to buy, as a recent article on the WSJ put it

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.”

However, even the seasoned fund managers like Bill Miller can’t avoid making wrong investment decision. His Legg Mason Value Trust Fund (LMVTX) beat the S&P 500 for 15 straight years until 2006. Then when the financial crisis reached it peak in 2008, the fund lost more than 55% in one year. That was 18% lower than the return of the benchmark in the same year, according to Morningstar data. Even though 2009 was the year that the average return of actively managed mutual funds beat their index peers by 1 percentage point (32.8% vs. 31.7%), index funds won the battle if we look at the period after the March 9 lows. From March 9 to December 31, 2009, index mutual funds gained 82% vs. 73% gain of active funds.

The debate between passive funds (index funds) and active funds will sure to continue and people will keep investing in the latter (I am still holding all my actively managed funds and keep investing in them every month), probably even so after the robust year of 2009 (LMVTX returned 41% last year, beating the S&P by 14%). However, before deciding where to put your money, in an index fund or an actively managed funds, there are a few things you need to keep in mind, as the WSJ article suggested:

  • A good run will not last forever: Bill Miller is a good example of what the market could do to a veteran investors. Though the fund recovered a little bit in 2009, it has lost nearly 67% from the peak in October 2007. Another example of a great fund turning sour lately is Dodge & Cox Fund (DODGX).
  • Expense ratios vary widely: Expense ratio (ER) is the fee that investors pay the fund manager(s) to research what to invest in addition to other administrative cost. Index funds win the cost battle by a wide margin as index funds involve only passive investment strategies.
  • Other fees can add up: Though I invest in active funds with higher ER, I always stay away from funds that charge a 5% front load fee to just begin to invest in them. Plus, I always buy funds from the fund companies directly, not from a brokers. While the fund it self may not have a commission, many brokers do charge a transaction fee when investing in a mutual fund through them, unless it’s a no-transaction fee fund.
  • Short-term gains can be taxing: Since managers of active funds have to trade frequently in order to “beat” the market (a fund’s turn-over ratio will give you an idea of the fund’s trade), the fund will distribute more short-term capital gains, which are taxed at a higher rate, sometimes as high as 35%.
  • If it acts like an indexer… Then maybe it’s better to just buy an index fund since the fund manager may have realized that he/she can really beat the index fund but still wants to charge a higher fee.

Photo credit: BusinessWeek

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2 Responses to “Actively Managed or Index Funds?”

  1. Jason Unger |  Jan 21, 2010 at 4:37 pm

    I think this chart says it all:

    http://www.automaticfinances.com/stock-picking-experts-coin-flippers/