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Don’t oversimplify

telescope.mapBy Bob Landaas

Many actively managed stock funds are outperforming the indexes so far this year. I find that reassuring.

There has been a litany of articles in the press about the average actively managed fund not performing as well as the index funds in 2014. That always gets my goat. What they fail to mention is that there are dozens and dozens of funds that consistently outperform the averages.

Last year, two-thirds of investor funds flowed to indexes.  So the concept of one-stop shopping – putting your money in a couple of index funds – is appealing to a lot of people because it saves them a lot of time. The problem is that they’re taking more risk than they should. They’re oversimplifying their financial affairs.

Investors need to remember that the issue is risk and return.

You want to make sure that when you look at return, you’re measuring risk. Many active managers are able to reduce the risk in their funds through careful stock selection, as opposed to eating everything at the buffet table.

When you look at these articles, it’s important to remember that the fund families that promote indexing have an ax to grind. They’re not the least bit objective. How many times can I hear John Bogle talk about index funds without demanding that he start honestly talking about the issue? Because it’s not just return.

Particularly for people who have more than a couple of dollars put together, you want to avail yourself of more sophisticated approaches in money management that employ thousands of different types of managers that are all going about it a little bit differently. They’re all buying different types of asset classes, and that’s the best way to reduce your risk.

Bob’s View
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We know that diversification isn’t numeric. It’s not just spreading your money out among a number of different funds. It’s buying very different asset classes – classes that trade differently from one another, that have different valuation levels. We know that over time, that’s a wonderful way to reduce the risk. You’re flat out not going to get that from index funds.

Indexes have been popular before – in the latter innings of long bull markets when large-cap value stocks tend to do well. That’s because a lot of index funds are weighted in large value. So if someone comments that the average active fund doesn’t outperform the index, well, no kidding because there are a lot of knuckleheads running mutual funds that probably ought to do something else for a living than drag down the averages.

As investors, it’s easy to get lulled into complacency and forget that markets change, sometimes favoring small-caps, sometimes growth stocks, sometimes international investments – outside the focus of an index fund.

We know there are a couple areas of the market, like large value, where it’s difficult for active managers to consistently outperform the indexes. But we also know, by contrast, that in the growth area of the market, in small caps and international, that active managers – the good ones – fairly consistently outperform the indexes.

Many astute active managers have reduced their oil holdings as forecasts have shown that the price of oil may be down for some time. Meanwhile, most index funds include oil stocks, meaning if you’re in those funds, you’re stuck with those picks. Similarly, index funds lock you into utilities and other interest-sensitive stocks that tend to fall apart in rising rate environments.

I personally have followed dozens and dozens of funds for decades that do a really good job of reducing risk and performing well. I implore people to look at the data, to be objective about it and realize that active management, in my opinion, is really the only way to go for sophisticated investors.

It’s risk and return. You can’t look at one without the other.

An 11% return is not a better deal than 10%, if your 11% is very volatile, and you’re afraid to open your statement. I’ll take 10% all day long if I get a much smoother ride, compared to a bumpy ride at 11%.

Don’t focus just on return. That’s only part of the equation. The other part is how much do you get jerked around? How volatile are your assets? The smoother the ride, the more comfortable you’re going to be with your wealth.

Bob Landaas is president of Landaas & Company.

(initially posted March 24, 2015)

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