There’s great debate in the investment management community on whether to take an active or passive role in managed funds. Before you decide what’s best for your association, be sure to ask the right questions.
In today’s financial world, there are hundreds of market indices, and each tracks the performance of a specific asset class in a specific manner.
Passively managed funds, commonly referred to as index funds, are simply portfolios that seek to replicate the performance of a particular index. The largest mutual fund in the world, the Vanguard 500 Index, has one goal: Match the return of the S&P 500 Index. On the other hand, actively managed funds set the clear objective of not matching but outperforming a particular market index.
Most assets invested in the global capital markets are actively managed, but index fund investors are rapidly gaining ground. In 2016, 19 percent of mutual fund assets were indexed, an increase from 9 percent in 2006, according to the 2017 Investment Company Fact Book [PDF]. The trend toward indexing in recent years is very real, which in turn makes it important to understand its issues.
The case for passively managed funds. Index fund investors believe that the markets are “efficient,” meaning that securities are priced fairly in the market. Therefore, it is not possible for individuals to outperform the market because underpriced securities—those trading below their fair price—do not exist. Trying to “beat the market” by researching securities that may outperform broader market indices will only add costs that eat into returns. Index funds are low-cost investments because no such research is required. And passive advocates argue that data suggests few actively managed funds can beat a market index.
The case for actively managed funds. Investors in actively managed funds believe that the markets are not inherently efficient and that careful research will identify mispriced securities that fare better than a market index. Active investors believe that the additional costs associated with finding these securities will be made up for by a higher investment return.
Your investment strategy decisions will involve a wide variety of considerations. Here are three caveats to bear in mind as you evaluate an index versus managed approach:
Don’t make a broad-stroke decision. The decision to go active versus indexing can depend on the asset class. Since most associations have diversified their investment reserves across a variety of asset classes, they should consider making their decisions at the asset-class level.
For example, the large-cap U.S. equity markets, which include the largest companies in the nation, are largely believed to be efficient. The theory is that there is so much information available on a large, commonly known company (such as Apple) that an active investor is unlikely to discover something that might provide an informational edge; consequently, the stock is priced fairly.
An association’s large-cap equity piece might be a good candidate for indexing. But what about its international equity allocation? Information about foreign stocks may be less readily available and need to be considered in the context of currency fluctuations and potential political risks. These factors may result in the stock not being priced fairly in the markets, creating opportunities for active managers to add value. So, while indexing may be a great idea in large-cap U.S. stocks, it could be a less successful strategy in foreign stocks. Our firm has conducted research [PDF] on this subject that supports the idea that the probability of outperformance varies by asset class.
Don’t forget about risk. Much attention is focused on relative performance of active managers against benchmarks—simple data that is used quickly to justify a case for active or passive management. Unfortunately, less attention is placed on relative risk. Since investors should be striving for superior risk-adjusted returns, this focus needs to be an important part of the conversation. Is it acceptable to underperform a benchmark if you have taken less risk to do so? Is it a victory if you’ve outperformed a benchmark by taking significantly more risk? Your association’s philosophy on risk should be a component of the active versus passive decision.
Don’t assume everything can be indexed. Certain asset classes that may be in your portfolio, such as alternative investments, are difficult if not impossible to replicate in an index fund format. Furthermore, if your association has a socially responsible investment component—for example, a health-related organization that will not invest in tobacco companies—indexing can become a logistical challenge. By definition, an index fund cannot pick and choose its securities—its mandate is to mimic its target index. If your goal is to exclude certain stocks under any circumstance, you cannot invest in an index fund without risking a violation.
Of course, these are only three considerations, and this question should be explored in a thoughtful way from multiple perspectives. While advocates from the investment management industry have responded to the debate with simple answers, the reality is that the issue is anything but.
The content of this article has been obtained from a variety of sources that are believed, though not guaranteed, to be accurate. Opinions expressed do not necessarily represent the views of ORION Investment Advisors, a DiMeo Schneider & Associates, L.L.C. firm. The content does not represent a specific investment recommendation. Please consult with your advisor, attorney, and accountant, as appropriate, regarding specific advice.
