With so many stories out there talking about the benefits of index funds vs. managed funds, it is hard to separate the wheat from the chaff. But is one type of fund better than the other or can they coexist?
“We have been zealots of indexing,” said Rodney Comegys, principal in Vanguard’s equity investment group. “They are a low cost way to get returns.”
That said, Vanguard has a “lot of great active funds we utilize for our investors. Active and passive can coexist, but indexing is a great way to get returns these days.”
The problem with just holding one or the other is that investors aren’t diversified enough, and when that one investment drops everything can be lost.
Brooks Mosley, president of Security Ballew Wealth Management in Jackson, Miss., said that he has always been a big fan of active managers and has used them since the 1990s.
“Everybody kept telling you you were an idiot if you used active managers because they cost more, and as the stock market was going up, it was hard to beat an S&P 500 index,” he said. But at the end of 1999, when the S&P 500 collapsed and was back to where it was the decade prior, investors who only owned index funds lost a huge chunk of their retirement funds.
Mosley likes to compromise between the two types of funds. “We will blend in active managers with index funds,” he said.
Index funds, besides being lower cost than managed funds, also offer investors an opportunity to invest in a specific segment of the market or a specific country.
The low interest rate environment makes Mosley nervous because when interest rates do start to rise again, “bond funds are going to be hit hard. When that does happen, it is good to have someone on board to manage that interest rate risk,” he said.
All managed funds are not created equal. They can’t all be lumped into the category of doing worse than the index funds. Many have done really well.
Mosley highlights Bill Gross at PIMCO, who saw a five-year return of 8.95 percent and only charges 71 basis points. During the same time period, Vanguard’s bond market index, which charges 22 basis points, returned 8.57, which wasn’t too far off, but Vanguard’s Total Bond Market Index returned only 6.71 percent during the five-year period, “almost 200 basis points between active vs. index,” he said.
Where index funds “serve a great purpose and make a lot of sense is if you are trying to go into a particular country, using an index is so much more cost efficient than getting an active manager who likes owning indexes of those funds,” Mosley said.
He pointed out that just because a fund is cheaper doesn’t mean it is a better option for some investors. Many managed funds take fewer risks but cost slightly more than an index fund would.
“It is great to earn 9 to 10 percent, but if you can earn 6 or 7 percent and take less risk, some people would be more comfortable with less volatility in their account,” Mosley said. “Every person is different and the days of just owning the S&P 500 are way behind us. There are so many indexes available. It is almost overwhelming, to tell you the truth.”
There are good active managers out there, you just have to search them out, Mosley said. “Unfortunately, active managers are like football coaches, they can have a good run with their team and then fall out of favor. People buy them after a good run and they get favorable press, but then they get a lot more money to manage and they don’t do as well.”
Many investors will cut their losses and switch after a bad run and that has hurt quite a few over the years because just because a manager had one bad year doesn’t mean they will continue to do badly, he said.
Vanguard’s Comegys put the index vs. managed fund question in simple terms. “If you have a great active manager who is capable to outperform the index, minus the costs he is charging” you should use an active manager. “If you don’t have an active manager you think is above average in performance and able to outperform the cost side, indexing is a good choice. It is hard to outperform, in a lot of cases. Determining in advance the best active manager is hard,” Comegys said.
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