Debating Active Managers vs. Index Funds

The active vs. passive debate may be one of the biggest in the investing world, but in the minds of investors themselves, the active funds still appear to hold sway.

With markets soaring in the 1990s, many investors discovered index mutual funds, or "passive" funds, which track benchmarks.

Index enthusiasts figured that they could mechanically buy S&P 500 funds and hold them for the long term. Some analysts predicted that investors would eventually stampede to index funds and abandon actively managed portfolios -- which employ managers who attempt to top the benchmarks.

But lately, actively managed funds have enjoyed enormous growth. In 2007, American Funds, an active manager, had inflows of $74 billion, according to Financial Research Corporation. Other active fund groups that recorded more than $10 billion in inflows included Dodge & Cox, Franklin Templeton and T. Rowe Price.

Of the $12 trillion held in mutual funds, about 90% is in actively managed funds, says Avi Nachmany, research director of fund tracker Strategic Insight. The market share of index funds has remained static in recent years, and it is not likely to grow in the future, says Nachmany.

"Many retail investors are anxious about investing in stocks, and they feel more comfortable when a professional manager watches the assets in an active fund," says Nachmany.

To be sure, exchange-traded funds, which track benchmarks, have been growing. But the ETFs account for only $600 billion in assets. So active mutual funds still control the market, dominating retirement plans and growing relentlessly.

Part of the recent appeal of active funds is simple performance. During the decade ended in April, Vanguard 500 Index ( VFINX), the granddaddy of S&P trackers, returned 3.81% annually, according to Morningstar. During the same period, the average large blend fund, a group that includes mostly active portfolios, returned 4.00%.

Not only did the S&P portfolios lag active funds, they also trailed intermediate-term bond funds, which returned 5.03%. Those results run counter to academic research saying that S&P 500 index funds should outdo bonds and most active funds over the long term.

Despite their weak recent showing, S&P 500 index funds remain fine choices because of their low fees and tax efficiency. But investors should be aware that index funds often do best in roaring bull markets. This occurs because of the structure of most index funds. Since stocks in the typical S&P fund are weighted according to market capitalization, big companies have a disproportionate impact on index returns.

During the late 1990s, the S&P 500 was dominated by 50 giant growth stocks. As these popular shares climbed, the index surpassed most active funds. But when the favorite stocks fell, the index collapsed.

In contrast, actively managed funds have flexibility to go wherever they want, avoiding overpriced stocks.

"In a bear market, active funds can beat the index by holding cash and controlling the risk in their portfolios," says Lewis J. Altfest, a financial advisor in New York.

Examining performance under different market conditions, Morningstar found that only 39% of active large-cap domestic funds outdid the benchmark during bull years when the S&P rose more than 10%. But when the market recorded a loss or single-digit gain, 57% of active funds surpassed the benchmark. In 2007, an erratic year when the S&P rose 5.49%, 54% of active funds topped the index.

Just as active funds have thrived in the domestic equity category, they have also dominated other areas. In 2007, investors poured $208 billion into foreign funds, with most of the money going to active funds, such as American EuroPacific ( AEPGX) and Thornburg International Value ( TGVAX).

Strong performances helped attract the assets. In 2007, the average foreign large blend fund returned 12.71%, more than a percentage point ahead of the Morgan Stanley Capital International EAFE index, the benchmark for popular index funds, such as Vanguard Developed Markets Index ( VDMIX).

The strong showing of the active funds points to a weakness of index funds: They can become outdated. The Morgan Stanley EAFE, the industry standard for years, was designed at a time when pensions and other investors had little interest in the emerging economies. Consequently, the index does not track stocks in countries such as India and Brazil, some of the best-performing markets in the world.

While an EAFE-tracking index fund would be forced to avoid emerging markets, active funds have been free to roam the world, picking the most attractive stocks.

Active funds are particularly dominant in fixed income. Of the $1.5 trillion in bond funds, 94% is in active funds. Developers of index funds have been slow to bring out new selections partly because it is difficult to design portfolios that match the benchmarks for corporate and municipal bonds.

Since there are tens of thousands of issues, picking a cross-section is a complicated task. Lately, a few municipal ETFs have appeared. So far these hold about $500 million in assets, compared with $365 billion for active municipal funds.

It seems safe to forecast that in the municipal category, actively managed funds should continue to maintain their grip on the market for years to come.

Stan Luxenberg is a freelance writer who specializes in mutual funds and investing. He was formerly executive editor of Individual Investor magazine.

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