Active, Passive Funds Perform Equally

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And the winner is ... well, it looks like a draw.

At least that’s the conclusion reached by a new study of the long-running debate over active and passive mutual funds. FundQuest, a firm that provides services to investment advisers, brokers and other financial services companies, looked at 30,000 mutual funds in 73 categories during the 30 years ended Feb. 28.

The study concluded that investors are best served by a mix of active and passive funds. But like many such studies, this one focused on investment returns, and investors may want to consider some other factors as well.

To back up, active funds use analysts and money managers to search for the most promising stocks or bonds. Passive funds, also called index funds, merely buy and hold the securities in a common market gauge, such as the Standard & Poor’s 500, seeking to match the market’s returns rather than beat them.

Passive funds tend to have much lower expense ratios because they do not have to pay all those experts. Many academic studies have concluded that passive funds offer the best long-term results, mainly because active managers cannot consistently pick enough market-beating investments to offset their higher expenses.

But there are exceptions. Among the 73 fund categories, FundQuest found that active funds did better in 23, passive ones in 22. In the remaining 28 categories, the two types did about the same. Categories in which active funds did better included communications and consumer staples stock funds, emerging-market bond funds, precious metals funds and many foreign-stock funds.

The active funds that did best tended to be in foreign markets and niche markets, such as funds that invested in growth stocks of small companies, or in precious-metals stocks. This seems consistent with a widely held view that active managers have a better chance of finding bargains in inefficient markets, where research and analysis is skimpy or prices are volatile because of thin trading.

It’s much harder, on the other hand, to find radically underpriced stocks among the 30 in the Dow Jones Industrial Average, since they are all heavily scrutinized and constantly traded.

But can an ordinary investor put FundQuest’s findings to practical use? That would be a gamble. There’s no way of knowing, for instance, that the patterns of the past 30 years will be repeated in the next 30. In fact, many foreign and niche markets are now getting much more attention, making mispriced securities scarcer.

Also, the typical investor will pick just one or two funds in each category chosen, while FundQuest averaged results for all the funds in each category. Even if you pick the funds with the best results in the category, you cannot be sure the manager was skilled, not just lucky.

Generally, it’s more work to invest with active funds than passive ones, because it’s harder to do better than average instead of settling for average. Active funds tend to be more volatile, having especially good years and especially disappointing ones. The investor must decide when to ride out a downturn and when to jump to another fund, which can trigger an unwelcome tax bill. Passive investors are more likely to ride the roller coaster to the end because they know a setback is not the fund manager’s fault.

Finally, there’s the issue of what to do when your star manager quits, retires or dies. Will the new one be as good? Statistically, that’s unlikely, since the average fund manager cannot be above average. With a passive fund, it doesn’t really matter who’s at the helm.

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