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When Active Funds Outperform Index Funds

By Peter Mastrantuono

One of the great investment debates of the last decade has been centered on the relative merits of active versus passive investing. It can now be reasonably argued that the debate is over: passively managed funds (funds that replicate a market index like the Standard & Poor’s 500 Index) have generally outperformed their actively managed cousins over the long term. 

And, investors have voted with their dollars. Just this month, the Wall Street Journal reported that funds that mimic stock indexes for the first time hold more money than funds that seek to beat the market.

So, has the case finally been shut on this great question of active versus passive? Maybe not.

Beware of Averages

Milton Friedman, the great economist, once cautioned against walking across a river whose average depth was three feet. Averages can be deceiving. Unquestionably, the research shows that passively managed funds have, on average, outperformed actively managed funds. Yet, the data also show that there have been a substantial percentage of actively managed funds that have outperform their benchmark indexes over sustained periods.

Morningstar, a highly regarded fund investment research provider, publishes a semi-annual analysis of the relative performance of actively managed and passively managed funds.

In its year-end report, Morningstar found that 38% of active U.S. stock funds outperformed the average of their passive peers in 2018, while 46% did so in 2017. Over a longer, ten-year period, 24% of actively managed funds outperformed.

At initial blush, these results suggest that index investing is the superior investment approach. But, like many first impressions, this interpretation may be misleading.

For many investors, outperformance is critical to overcome a late start in saving or years of under saving. For others, it just may mean that they get the option of retiring earlier.

Investors don’t need 100% of actively managed funds to outperform their market benchmark. They simply need to identify those funds in each relevant asset class that have consistently delivered above-average market performance. A financial advisor can be an essential resource in uncovering such funds.

Where Active Management Works Best

The active vs. passive debate is not as black and white as many investors and commentators believe. It yields no universal, hard-and-fast guidelines for investors, only nuances in which the answers very often depend on the specific markets in which individuals are investing and what their overall investment objectives may be.

For instance, the Morningstar Active/Passive Barometer referenced above found that the proportion of active fund outperformance was much higher in less efficient markets, like emerging markets and small cap stocks.

Moreover, for the preponderance of investors, performance is not defined by investment returns alone. Performance, from a more expansive and more intelligent perspective, includes other elements, such as risk and an investment’s correlation with other holdings within an overall efficient portfolio.

Above all, investment performance expectations should be set to the benchmark return incorporated within an individual’s financial plan rather than to a broad market index unrelated to the achievement of personal financial goals. 

Peter Mastrantuono is a contributing writer to http://www.myperfectfinancialadvisor.com, the premier matchmaker between investors and advisors. Peter worked for over 30 years in the wealth management industry, focusing on retirement planning, investing, asset allocation and financial planning.

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