Well, it's better than daytrading.
As the equity markets continue to churn, investors are flocking to actively managed funds in hopes of beating a losing market. But market timing rarely works, even if you're paying someone else to pick the stocks for you.
Because it's nearly impossible to beat the market, the benefits of index funds are obvious. Since equities are the place to be for the long haul, it
pay to ride along with the market. Plus, there are the super-low costs of index funds. Because they require very little management, management fees are almost nonexistent. The "manager" simply adjusts how much of each stock the fund holds based on any changes in the underlying index (such as the
) or on whether cash must be raised for shareholder redemptions.
Also, the minimal trading in index funds means two more benefits: Transaction fees are much lower than in most other funds, and indexing creates better tax efficiency. (Fewer sales means fewer realized gains that would incur a tax.)
Plus, over long periods of time, index funds typically provide higher returns than their actively managed counterparts, in large part because of their lower costs. For example, the average fee for an index fund is 0.55%, whereas for an average equity fund, it is 1.21%, according to Morningstar.
Despite these benefits, index funds don't provide any protection against a falling market. Indeed, as the index falls, so will your investment. While it's often advisable to take your lumps with the rest of the market and wait out a poor economy, it's no surprise investors have lately become more susceptible to the lure of active management.
Investing in actively managed funds can be tricky business, though. If you're determined to try to beat the market with an actively managed fund, consider keeping them in tax-advantaged accounts, such as an IRA, which will minimize the sting of the higher costs.
Here are a few more things to keep in mind when choosing a fund.
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Obviously, there's no reason to invest in an actively managed fund if it's not likely to beat the benchmark it tracks. "First, take a look at how it does against the index," advises Morningstar fund analyst Peter Di Teresa. "And look at returns from at least a five-year period, if not longer. Anything shorter than that is useless, and just reflects a lot of noise in the marketplace."
While you're at it, don't forget to check the manager's tenure. It doesn't matter if a fund has beaten its benchmark for 10 years running if the current manager just started a year ago.
Too often, people hear "benchmark" and automatically think "S&P 500." True, the S&P is a good proxy for the economic health of the market, even the overall economy, but it's not necessarily the benchmark for any one specific fund.
The S&P 500 is a good benchmark for large-cap growth funds. But if your small-cap value fund beat the S&P in 2001, who cares? The market runs in cycles; the universe of small-caps will sometimes beat the universe of large-caps, and vice versa.
In other words, nearly any small-cap fund could beat the S&P 500 when small-caps are riding high. In this example, it's far better to measure a small-cap value fund's performance against the Russell 2000, as well as against its peers.
The Asset Class
Some asset classes lend themselves more to active management than others. Large-cap index funds are notoriously hard to beat, and virtually impossible to beat consistently. Over the past five years, just 664 out of 1,416 actively managed large-cap funds beat the average large-cap index funds, according to Morningstar. But even for those who think a 47% chance of beating an index fund sounds pretty good, think again. "Those aren't the same funds consistently beating the index," warns Larry Swedroe, a financial planner and author of
Rational Investing in Irrational Times
Real estate funds, though, are an area in which active management routinely beats the Real Estate Investment Trust index. Because the NAREIT index essentially tracks the universe of REITs, including some of the tiny ones, fund managers can easily beat it by simply not owning a few of the dogs.
The Value-Added That the Manager Brings
It's virtually impossible to tell which fund managers have just been lucky, which have made brilliant decisions, and which rely on both. But steer clear of funds that seem to rack up big gains in a short amount of time. Such cases are often more indicative of a lucky break than a repeatable, sustainable system of investment.
For instance, let's say two large-cap funds with good histories each beat the S&P 500 by 3% in the past 12 months. If one fund achieved its 3% edge over the S&P in two quarters from overweighting a couple of tech stocks that skyrocketed, while the other beat the S&P 60% of the time, the latter might suggest more strategy than luck.
The Size of Bets
The same goes for the number of stocks in a fund. Concentrated funds that hold just 20 stocks, for instance, can do remarkably well in the best-case scenario. Timing that scenario, though, is nearly impossible. And if, say, an
makes up 5% or so of the fund, it can take a good six years for that fund to get back on track. Better to steer clear of such volatility.
Some stock rotation is fine, even beneficial. After all, one of the reasons you pay higher expenses for an actively managed fund is because you think the manager's discretion warrants the premium. So don't worry too much if you see a large-cap fund drift from value to growth or vice versa. Companies make that shift with some regularity, and, if a manager likes a company, he's entitled to hold it.
Moving from large stocks to small stocks, though, could be a warning sign, says Harin De Silva, of Analytic Investors, which subadvises the
PBHG Disciplined Equity Fund and the
UAM Analytic Defensive Equity Fund. "There's much more forensic accounting involved in covering small-caps," De Silva says. "Plus the quality of management becomes more of an issue."
If a large-cap fund manager tries to bolster returns by loading up on small-caps when small-caps are in favor, get out. Not only will that upset your asset allocation, but also you're not necessarily getting the best management for your investment.
Your Own Risk Tolerance and Patience
Don't overestimate your own willingness to put up with the bad in your funds. Hopping in and out of funds can undercut even the most exceptional returns from actively managed funds. That said, actively managed funds require a bit more oversight than index funds. You'll need to keep an eye on manager defections as well as returns to ensure that the fund is still right for you.
If you prefer to choose a fund and forget about your investments, maybe you should forget about active management.
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