In the mutual fund industry, it's a debate that will never go away: Is it worth paying fund managers to monitor investments? After all, active funds are more expensive, and recent performance indicates it has been a difficult few years for active management.
According to the S&P Indices Versus Active Funds Scorecard [SPIVA], more than 84% of actively managed U.S. equity funds underperformed their S&P benchmark last year, and an average of 56.6% have underperformed over the past five years.
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The S&P 1500 index, which combines the S&P 500, the S&P MidCap 400 and the S&P SmallCap 600, returned approximately 1.8% last year, and although that’s a modest gain, the index handily beat actively-managed U.S. stock funds. U.S. stock funds lost an average of 2.6% in 2011.
On average, index (passive) funds typically have lower fees than active alternatives. The expense ratios of actively managed funds range from approximately 0.5% to 2%, compared to index funds which charge fees as low as 0.05%.
The reason for an active fund’s higher fee is the added cost of a manager. The manager doesn’t track an index, but aims to beat it by carefully selecting stocks. so if you’re going to pay a higher fee, your fund manager should be worth the extra cost. But finding a manager with great potential is extremely difficult, and according to Michael S. Falk of the Focus Consulting Group, it’s close to impossible.
“Picking fund managers who have a great track record is child’s play,” said Falk. “But picking a manager before they do a good job is very, very difficult.”
So is the added price worth it? Not according to the recent results. SPIVA reports that 81.3% of large-cap funds, 67.4% of mid-cap funds and 85.8% of small-cap funds failed to beat the S&P 500, S&P MidCap 400 and S&P SmallCap 600 over the past year. And last year wasn’t a fluke; approximately 69% of large-cap funds, 70% of mid-cap funds and 51% small-cap funds underperformed their respective benchmarks over the previous three years.
But maybe it’s not a mutually exclusive deal. According to Falk, it’s smart to hold active and passive funds in an investment portfolio. “It’s important to find a balance between index and active funds,” said Falk. “It’s smart to allocate 40%, 50% or 60% of an investor’s portfolio to active funds and let index funds occupy the rest.”
So how should you identify attractive active funds?
“It’s a constant battle,” said Falk. “Investors need to figure out who has low fees, who’s taking on new clients and what managers will add value.”