When to use Active Management

After a steady rise in the markets lasting through the first half of the year, we have seen some more volatility and uncertainty since the Fed began their discussion of tapering their stimulus over the past few months.  Mutual fund shops have increased their sales pitch during this time stating that in volatile markets an active manager can  outperform Exchange Traded Funds (ETF’s – broad index based investments) because of a manager’s stock picking ability.  This has long been the message advantage of investing in a mutual fund and paying the high fees associated with such funds, but do they really outperform an index (such as the S&P 500) in volatile and down markets?

A recent study titled “Modern Fool’s Gold: Alpha in Recessions,” written by Shaun A. Pfeiffer and Harold R. Evensky, studied active managers over a 20 year period between 1990 and 2010 and determined that on average, actively managed stock funds did not generate the type of returns to offset their fees in volatile and down markets. If active management cannot outperform in volatile markets, and we have seen that 65-80% of active managers have trailed their benchmarks since the bottom of the “Great Recession” in March of ’09 in a rising market environment, then under what scenario would it be beneficial to select a mutual fund rather than just follow an index by investing in ETF’s?

From our research, the primary decision parameters on whether to use active management is based on the asset class we are trying to get exposure to and whether it is an efficient market where a manager can add value.  Since the equity markets are such efficient markets, it is more difficult to find value in stocks through active management.  Because of this, we tend to strategically invest in equity asset classes through an ETF which gives us broad exposure to an asset class with lower fees for our clients.  We find a different outcome when it comes to the fixed income market however, since the debt market is so vast and inefficient, we feel that active managers can add alpha and value to a portfolio.  Even in the asset classes where active management can add value, research and due diligence regarding these managers is key, as well as choosing the right class of mutual fund.  Some classes include hidden fees that you may not realize you are paying but can be a real drag on a portfolio’s performance.