The naysayers’ argument in recent years has been a powerful
one: The odds are against active managers beating the market. Most haven’t
beaten the market since 2008. But many
advisers still believe that at certain times, and for certain strategies,
actively managed funds are superior to index funds. That is particularly true,
they say, if the active fund has a good long-term track record and charges
lower management fees than most of its peers. Here’s a closer look at those
scenarios where experts say the case is strongest for active management:
1. When You Own
Stocks for Income
As yields have fallen, investors have flocked to
dividend-paying stocks for income, and that has spurred rapid growth in
dividend-focused ETFs. But to enhance their appeal, companies that sponsor such
ETFs often design them with an easy-to-grasp mission—such as generating the
highest yields or owning shares only of companies that consistently boost dividends.
Such ETFs often focus narrowly on certain sectors, such as
economically sensitive or defensive stocks. They only sell a stock if it no
longer fits the mission. Meantime, if market sentiment shifts away from the
sector where an ETF is focused, that can hurt its overall performance. An
active manager could limit the impact of such shifts by diversifying. While the
ETF charges only 0.10% in expenses, the active fund charges 0.31%, which is
still significantly lower than most actively managed funds in Morningstar’s
large-blend category.
2. If Markets Start
Trading Sideways
Less than a fifth of large-cap U.S.-stock managers have
beaten their benchmarks over the past five years. Performance actually was a
little worse from 1995 to 1999, with only 18% topping the S&P 500 index.
Returns for actively managed funds lagged behind those of the S&P 500 by an
average of more than four percentage points a year in that stretch.
However, the situation changed from 2000 to 2008, when
nearly two-thirds of active large-cap funds beat the S&P, by an average of
1.4 points annually. Historically, active managers have lagged behind
benchmarks during long, strong bull markets, when securities selection makes
less of a difference. They tend to make up lost ground when markets level off
or suffer corrections.
The bull market may still have life left. But if stocks
struggle and companies find earnings growth harder to come by, that is a
climate that would favor active management.
3. When You Own Bonds
Bond yields move in the opposite direction of bond prices,
so if rates are headed higher this year, it could be risky to own an ETF that
closely tracks a broad bond index. Some types of bonds would be particularly
hurt, including Treasurys and certain mortgage-backed securities.
One widely held bond ETF, iShares U.S. Core Aggregate
Bond (AGG), has more than half of its portfolio in such rate-sensitive
securities. That is because the index that the ETF follows reflects the
composition of the overall bond market, where Treasurys and mortgage securities
represent the largest types of bonds outstanding.
Flexible funds also can reduce overall rate sensitivity
through a range of derivatives transactions. And they can build cash positions
and move to the sidelines when certain market sectors grow expensive.
4. When Investing
Abroad
ETFs make it easy to get non-U.S. exposure. But those based
on market-cap-weighted indexes tilt toward the largest foreign markets,
sometimes exposing investors to weaker economies, including, for now, Russia
and Western Europe.
Actively managed international funds can fare better at
diversifying away from indexes. Over the
past 10 years, U.S.-stock funds in the top 25% of their Morningstar rankings
have beaten the S&P 500 on average by about one percentage point a year.
But large-cap international-stock funds in the top 25% of their rankings have
topped the S&P 500 on average by around 1.5 to 2 percentage points a year,
Morningstar data show.
Still, investors could lose the benefits of an active
foreign fund if they aren’t mindful of costs. When possible, investors should
opt for funds that charge significantly less than the category average for
annual expenses and that keep turnover—or the amount of trading they do—to
around 33% or less of an overall portfolio a year.
5. If You’re Worried
About Volatility
Limiting losses can help in building a nest egg. And some
ETFs aim to provide downside cushion by focusing on lower-volatility stocks.
These may include shares of large, blue-chip companies and those that pay
steady dividends, whose shares typically move much less than the S&P 500.
But active managers have more ways to play defense. They can
own higher-quality stocks and trim positions as valuations rise. Performance numbers can help identify such
funds—such as upside and downside “capture ratios,” which show how a fund’s
returns compare with the broad market in rallies and selloffs.
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