Why not have both types of funds?
Decades of research show the benefits of asset allocation using index funds. But new research suggests that many active strategies outperform over time, even after costing is factored in.
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Asset managers, including John Hancock and Morgan Stanley, have studied the issue of assets versus liabilities because it is in their best interest to determine the optimal return for their clients, balanced with the effect of management fees. .
Unfortunately, all too often this question is answered incorrectly. This is not a proposition either / or; the best long term results are obtained when you do both.
“The combination of active and passive strategies can help investors outperform and pursue other important goals while keeping costs and tax efficiency in mind,” wrote Leo M. Zerilli, analyst at John Hancock , in a white paper.
Active investing means placing your money in funds whose strategy is based on the managers’ ability to choose investments deemed likely to increase in value. In the past, active vehicles were exclusively in the realm of mutual funds, but today, actively managed ETFs are also easy to find.
In general, active managers strive to beat a particular benchmark. In addition, each fund has its own objective or its own philosophy.
For example, the Growth Fund of America (AGTHX), an active fund with $ 282.5 billion under management, “seeks opportunities in traditional growth stocks as well as cyclical companies and turnaround situations with significant potential. capital growth ”, according to the fund literature.
This fund is mainly made up of domestic equities. Its benchmark is the S&P 500.
Passive investors – and that includes many, if not most, clients of financial fiduciary advisers these days – you don’t try to identify valuation errors or securities that are trading at low multiples of their earnings.
Your goal is to achieve market performance, typically based on a wide range of global indices and indices representing various market capitalizations and sectors. Typically, you wouldn’t just buy an S&P index fund, such as the SPDR S&P 500 ETF (NYSEARCA: SPY) and call it someday. Instead, you are simply investing in a way that gives you broad exposure to the market.
However, many passively invested portfolios consist of a collection of index funds, which is a simple and inexpensive way to generate market returns.
As you can imagine, active management is more expensive, as security selection requires not only a manager but also research analysts. In addition, the higher frequency of transactions adds costs. This is why actively managed funds have higher fees than index funds.
This is one of the arguments put forward by index supporters: Lower fees mean index funds are cheaper, which translates into higher returns for account holders. Less money comes out of the fund and goes into the pockets of managers.
Combine active and passive strategies
Although the active / passive debate tends to present the two approaches as being at opposite ends of the investment spectrum, more and more researchers are seeing the benefits of combining them.
In practice, many investors own both index funds and actively managed funds. For example, as an advisor, if a client came in with a taxable account that contained actively managed funds, I wouldn’t just trade it for a passive fund if the client had significant capital gains. This could result in a significant (and unnecessary) tax impact.
It is quite possible to substitute an active fund for an index fund, if the underlying asset class is the same. For example, you can use an actively managed national large cap fund, such as Fidelity Magellan (FMAGX) instead of the S&P 500 index. The Magellan fund is more growth oriented, so you would miss out on some value. , but in a pinch, that would be acceptable.
In this environment, where domestic growth dominates the market, this swap would work very well.
In a recent blog post, Dan Hunt, Senior Investment Strategist at Morgan Stanley, summarized the benefits of combining assets and liabilities more strategically.
The right fund for the job
“Active strategies have tended to benefit investors more in some investment climates, and passive strategies have tended to outperform in others. For example, when the market is volatile or the economy is weakening, active managers may outperform more often than when it is not. Conversely, when specific stocks in the market move in unison or stock valuations are more uniform, passive strategies may be the best way forward, ”Hunt wrote.
He added: “Depending on the opportunities in different sectors of the capital markets, investors can benefit from a mix of passive and active strategies – the best of both worlds, if you will – in a way that takes advantage of these. information. Market conditions change all the time, however, it often takes a discerning eye to decide when and by how much to prioritize passive investments over active investments. “
In other words, despite the debates you will find all over the internet, and perhaps in discussions with your financial advisor, there may be good reasons to use the best instrument to help you achieve your financial goals.