By Kyle Tetting

The continued growth of low-cost indexed investments has come largely at the expense of actively managed mutual funds.

The argument for indexing centers on the average active fund’s inability to consistently beat a benchmark as easy to track as the S&P 500. This has been particularly true in recent years as the broadest measures of the U.S. stock market enjoyed robust expansion with few periods of prolonged decline.

If the average actively managed mutual fund fails to consistently beat the benchmark, the argument goes, why pay for the added expense of active management?

Unfortunately, the argument for indexing fails to grasp the entirety of the issue.

For starters, it fails to account for a small subset of actively managed funds that do consistently outperform their benchmarks. Research from Morningstar and others suggests that portfolio managers who align their objectives with shareholders more frequently outperform.

Specifically, research cites significant outperformance in funds with lower-than-average costs and with portfolio managers with large stakes in their own funds.

As importantly, the argument for indexing fails to account for risk by focusing solely on the returns of the indexes compared to actively managed funds.

What is notable about many highly rated actively managed funds is that they tend to significantly outperform their level of risk. This differs from the index fund, which takes index (average) risk to achieve average returns.

With an eye toward not just return, but risk-adjusted return, many active managers can add substantial value to a diversified account.

Index funds can play an important role in a diverse portfolio by providing broad market exposure and limiting cost. However, some examples illustrate the role active management can play in managing risk and driving longer-term returns.

The easiest category to compare to broader indexed strategies is large cap blend. On average, funds in this category have underperformed the S&P 500 over periods of three, five and 10 years.

Factor in risk relative to the S&P 500, as measured by beta, and the underperformance of the category appears worse still. The category takes 102% of the risk over the last three and five years and 101% of the risk over the last 10 years, suggesting it should be able to generate outperformance.

While the category overall has failed to keep pace with the S&P 500, there is a selection of active funds in the category that do consistently add value.

These funds typically have long-tenured managers with a large stake in their own fund. They also tend to keep costs low when compared to the broader category. Most importantly, the funds tend to do a much better job of managing risk when compared to the category, either consistently generating returns on par with the index for considerably less risk or beating the index with a similar risk profile.

In either case, we can turn to a select group of active funds that generate consistently positive alphas, or return in excess of the fund’s level of risk.

Active vs. Passive
Read an article by Tom Pappenfus about how the argument between indexing and active management should not be an either/or proposition.

The large cap growth category as a whole adds minimal value for its risk when compared to the S&P 500. Even so, a number of large cap growth fund management teams have consistently outperformed the category and broader benchmarks through strong security selection. They also have outperformed either by taking less or better risk.

Large cap value funds face some of the biggest challenges in adding value over and above broader benchmarks. These types of companies are well researched and broadly covered by analysts and the media, typically resulting in fewer mispricings through which active managers might create opportunity.

As a result, the category as a whole has failed to add much value, but again, there are certain actively managed funds that consistently outperform the risk they take relative to the S&P 500. More often than not, the best large value funds capture most of the S&P 500’s returns with considerably less risk.

Generally, the more difficult a company is to research, the more advantages an active manager can have. While the average mid cap fund did not add much value in the last 10 years, some strong research-driven funds have been able to set themselves apart. This is due in large part to the more difficult nature of researching medium-sized companies.

In this category, above-average portfolio managers and strong stock analysis can add significant value over time. That’s an important point, given the above average levels of risk these funds take compared to benchmarks like the S&P 500.

Over the last 10 years, the average small cap fund underperformed its risk fairly significantly. This volatile category generally accounts for a small portion of most portfolios but can provide some meaningful returns in the right environment.

What is notable about the category’s best performing funds is that they each beat S&P returns with different risk profiles over the last three, five and 10 years. However, as with the mid cap categories, there tend to be greater opportunities for active management in small cap stocks because the companies are considerably more difficult to research.

Indexing assures that a portfolio participates in the volatility of the index but will underperform the index after expenses. The average fund may have a tough time competing, but there are some funds that are consistently above average. The managers of these funds manage risk better without meaningfully sacrificing returns.

Further, the more difficult a category is to research and invest in, the more opportunities exist for the best active managers to add value for investors.

Kyle Tetting is research director at Landaas & Company.

(initially posted Jan. 26, 2015)

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