Investment Choices: Index Funds vs. Actively Managed Accounts

Stamford and its surrounding communities are securely cemented as one of the asset management capitals of the world. As a result, residents have a myriad of choices of how to employ their capital in an effort to plan for and secure their financial future. 

Whether choosing to invest in individual equities, bonds, REITS and so on, one of the first decisions an investor has to make is whether to use an index fund, an actively-managed fund or whether they should instead employ an active manager for their proprietary account(s). The argument of which is the best choice has raged on for years.

What is an Index Fund?

Index funds are passively managed portfolios designed to replicate the proportionate holdings of a target index. The Standard & Poor’s 500 index is one of the most recognized of the hundreds of market and sector index funds available to investors in the form of an index fund. Since the focus of the fund is to mimic the holdings and returns of a specific index, managers are able to leverage technology to effectively maintain the portfolio at a reduced expense, which typically results in razor-thin fees. 

You won’t get any argument from me that low fees are, in general, a good idea.  However, I would also caution that, sometimes, cheap advice could be very expensive. I suspect anyone who invested in the S&P 500 from 2001 through 2011 finds little comfort in having paid low fees for pedestrian returns on investment while being exposed to one of the most volatile market periods since the Great Depression.

What is an Actively-Managed Account?

Active managers come in several flavors and styles: value, growth, growth at a reasonable price (GARP), momentum, etc. Some manage mutual funds while others may manage your individual portfolio. However, they all share one common trait: they are not constrained by the limits of an index and are free to make investment decisions based on the merits of the opportunity or, in some cases, take a defensive position in the market or simply move to cash.

This added flexibility provides active managers with one advantage over index funds — active managers have the potential to outperform a market or sector. Unfortunately, finding an active manager who can consistently outperform the market is no easy task.

Statistics — and the numbers will vary from publication to publication — state that over 80 percent of actively-managed U.S. Large blend funds and more than 60 percent of actively managed U.S Small Value funds underperform their benchmark on an annual basis. Sometimes ignored, of course, is the glass-half-full fact that close to 20 percent large cap blends and 40 percent of small value funds equal or outperform the indexes, so some strong performers do exist.

In the end, the adage “buyer beware” is as appropriate in picking investment managers as it is in buying a car or a home. It’s a significant decision, and there is not one single solution that is right for everyone. Do your homework and ask questions, and if you don’t understand the answer, ask again.