Active versus passive is false funds debate over investor style

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March 20, 2007|By Charles Jaffe | Charles Jaffe,Marketwatch

The financial adviser was on the air and on a roll, telling anyone listening why he likes actively managed mutual funds and dislikes index funds.

Out came the statistics about how, since the stock market peaked, a large percentage of active funds have beaten their indexed peers. And in listing a few of his favorite funds - including a couple with alarmingly high expense ratios - he brought out the big guns.

"Yes," he said as his voice rose to a crescendo, "index funds are much cheaper, but it's the same thing in mutual funds as it is with everything else in life, and I learned from my father 30 years ago that `You get what you pay for.'"

Actually, in mutual funds, about the one thing of which you can be certain is that you get what you don't pay for, since the money you don't pay in higher costs stays in your account.

Die-hard index investors will tell you that their way is right, and will point to statistics to show how many fund managers - and individual investors - fail to beat the market index. Guys like the financial planner/radio jock, selling actively managed funds, will crunch the data differently to show the benefits of having the chance to beat the market, or to be protected from it when conditions get ugly.

It's a debate that goes all the way back to the start of index funds, but it's also time to acknowledge that if there's such a thing as a "right" answer in this squabble, it has almost nothing to do with the funds and virtually everything to do with the temperament of the individual investor.

For proof, consider some research completed last year by Thomas McGuigan of Burns Advisory Group, a financial planning firm in Old Lyme, Conn., coupled with some data on investor returns.

McGuigan set out to settle the debate of whether active or passive management is superior - at the time he relied heavily on active managers in his own practice - and came away from his research sure that most actively managed large- and mid-cap mutual funds under performed their benchmark passive strategies.

In each category, however, McGuigan also found that some active managers beat the benchmark, but that few did so consistently. Moreover, it was "difficult, if not impossible" to predict which managers would get the job done. "There was a high price you paid for being wrong, for picking a fund thinking it would be the one to outperform the benchmark, and then having it fall short," he says.

It prompted McGuigan to change the way he worked with customers, moving more toward the traditional index-fund investor.

"I came to the conclusion that lower-cost, lower turnover funds - broadly diversified global investments - were the way to go," McGuigan says. "We can still select managers we like for one reason or another, but we lowered costs, and we improved performance as a result."

It's a strategy that index fund investors live by, which is why McGuigan was concerned when he read a Morningstar Inc. report this year, showing that the average investor in index funds actually captured just 79 percent of the return that they should have gained (so if the index was up 10 percent, the typical investor gained 7.9 percent).

Indexing is designed to be a buy-and-hold strategy. Yet numerous studies show that investors in all funds tend to earn less than the fund does, because they buy in after a fund has shown big gains and sell out when a fund hits rock bottom. McGuigan was surprised to see that indexers lagged their benchmarks by so much. He figured that a rapid indexer would know better than to jump around.

His conclusion is a simple equation, one that explains the real reason why many investors are better suited to actively managed funds regardless of the cost/turnover benefits of indexing:

Real investor returns = actual investment returns +/- investor behavior.

"The second part of the equation is so important, because investors constantly hurt themselves," says McGuigan. "So the important thing is that investors believe in what they are doing. If they believe in passive investing, they need to believe it enough to stick with it; if they believe they can pick better managers, they need to give those managers a chance."

So the issue is not so much active versus passive - or a mix of the two - as it is: "Which can you stick with when the going gets rough?"

No matter which type of fund you buy, declines are inevitable. But if you can pick a good performer, active or passive, and stick with it to get the same results that the fund actually delivers on paper, that's when you'll have a portfolio that has a real chance of helping you reach your financial goals.

jaffe@marketwatch.com

Charles Jaffe is senior columnist for MarketWatch. His postal address is: Box 70, Cohasset, MA 02025-0070.

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