WSJ: “Actively Managed or Index Funds? Why Not Both?”

passiveactiveicecreamWe agree. We’re not alone. A recent WSJ survey showed that 42% of investors own both active and passive funds, while 36% own only actively managed funds and 22% own only index/passive funds. Some investors swear by index funds and some love only active management. It really shouldn’t be an either or decision.

Use indexes/passive funds for efficient markets. As the Economist pointed out in their February 22nd issue, “The costs of actively managed funds are higher than most investors realize”. Think of it, an active fund needs to do research, make lots of trades, spend lots on marketing to “sell” their strategy and therefore, their cost of operations can be 1.50% or more. An index fund merely replicates an index and cost can be as low as .05%. Is it any wonder that 60%-80% of actively traded equity funds fail to beat their market index each year? And, 60% to 90% of actively traded fixed income funds fail as well. Why? Active management has to overcome high fees, transaction costs and tax ramifications.

Expenses matter. A 1% difference in performance over long time periods can really add up. $100,000 invested that earns 6% for 30 years grows to $574,000. At 5%, it only grows to $432,000; a 25% reduction.

We believe that traditional capital markets work and price securities fairly. Despite what the financial press and fund marketing literature suggests, study after study shows the majority of active managers underperform. So, yes, passive/index funds are superior to active funds for equity and fixed income- traditional efficient markets. But, what about non-traditional inefficient markets?

Use actively managed funds for inefficient markets. The last two decades have seen a great proliferation of investments that are not correlated to the stock market. Many are publicly traded and easily redeemable. They often follow hedge-fund like strategies designed to reduce volatility. These liquid alternatives may include arbitrage funds, global tactical allocation funds, closed-end specialty funds, MLPS, and long/short funds. Studies have shown that adding non-correlated assets to a portfolio can improve return and reduce volatility.

These actively managed alternative funds will typically have an operating expense ratio in the 1-2% range. This is understandable. They do considerable research. Their trading costs are often higher due to the use of derivatives and lots of trades. And, yes, they have marketing costs to educate and inform prospects and clients. One benchmark for these funds might be an “absolute return” of 1-6% above LIBOR.

“Use a mix of passive and active funds to bring down overall expenses and to hedge against market crosscurrents” was the conclusion of the WSJ article March 4th. Again, we agree. The bulk of a portfolio, equities and fixed income, should be in index/passive funds, with a weighted average operating expense of perhaps .35% or lower.

Passive and active funds perform differently in various market conditions. While stocks were up 30% last year, fixed income did poorly and a basket of liquid alternatives we follow had an absolute return of 4%. Then, in January, when stocks lost 3-4%, fixed income rebounded and this basket of liquid alternatives was slightly positive. In short, a nice blend of passive and active funds is designed to help investors participate in the upside of markets and protect in down markets. And, because DWM is committed to protecting and enhancing our clients’ net worth and legacy, that works well for us and our clients. Very well, indeed.