A place for active management
Joel Dresang: Marc, we talk about actively managed mutual funds as opposed to passive index funds. The index funds keep getting more and more popular, but there are times in a business cycle when you want some active management in your portfolio. Explain that.
Marc Amateis: Oftentimes, early in the business cycle, when the stock market is moving higher, all the stocks are pretty much moving higher together. Sure, the small-caps often lead the charge, but then everything starts going up, and you can be in a passively-managed index fund at very low cost and do very well.
Later in the business cycle, active management typically shines because at that point, certain stocks are fully valued, certain sectors are fully valued, and active management can help find those sectors and those stocks where you still have room to run.
Think of a time back in 2011, for example, when you had high correlations between stocks because of an outside force, in that case, the U.S. debt downgrade, the European debt crisis. Active management wasn’t so important in that regard because everything was going in one direction together. However, you look at a period of time right now, correlations are at about 20% versus the 80% correlation back in 2011. So now active management and active stock picking can really pay off.
Joel: Why are indexes so popular?
Marc: Well, one reason is low cost. You’re not paying for active management. A computer is just re-balancing the index on a continual basis, and cost is important. Another reason, though, also, is the fact that it simplifies everything for people. And unless you have a good advisor and you have good active managers, you don’t see the benefit of active management. And that can be a major factor for people.
Joel: There’s also the misinformed impression that active managers charge more for stock picking and yet they can’t outperform the indexes. What’s wrong with that thinking?
Marc: Right. And that’s just not true. What you hear about are these studies that say the average actively managed fund doesn’t outperform the index.
There are a lot of fund managers out there that beat the indexes decade-in, decade-out. If you really look at it, over most time periods, about a third of actively-managed funds in the large-cap universe, for example, beat the S&P 500 index.
We know there are a lot of good actively managed funds out there that have shown over time that they consistently beat the indexes, even after their expenses, and they do it with lower risk.
Joel: And that’s the other point for investors, is that they shouldn’t just be trying to beat the index, right?
Marc: Right. That’s a real important part of it. So many investors focus in strictly on performance. You’ve got to look at the risk you’re taking. There’s nothing special about beating an index by a little bit and taking three, four times the risk, putting up with that kind of volatility.
One of the things that we really try to do is outperform our benchmarks, outperform the benchmark indexes but do it with lower risk. And if we can do that, we feel we’ve really helped the investor.
Joel: None of this is to say that investors should avoid passive index funds. What role do those funds play in a portfolio?
Marc: Joel, we use passively managed index funds here at Landaas. They have a role, clearly. We like to use them to get broad market exposure at very low cost and then to build what we call “alpha,” that is, performance above and beyond the passive index, using actively managed funds where they fit.
Joel: So what role do the active funds play?
Marc: Well, active funds hopefully can give you an opportunity to outperform the index with lower risk by finding those investments, those stocks, that are undervalued versus the overall market.
Some of the areas where active management really fits well is in some of the more outlying areas of the market, like emerging markets and small-caps and mid-caps and some overseas markets, where you really need good boots-on-the-ground research and active managers to ferret out those investments that are likely to do well over time.
The best thing that an investor can do is to take a long-term perspective, stay invested, stick to their investment discipline and plan. And then worry about the actual makeup of the portfolio.
And again, that’s where a financial advisor can really help, to keep an investor from making those kinds of mistakes as well as finding the best mix of active and passive investments – for what the investor’s trying to achieve over his lifetime.
Marc Amateis is vice president and an investment advisor at Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
(initially posted Dec. 30, 2016)