When should advisors consider investing their client monies in actively managed funds rather than cheaper passive index funds or ETFs, which tend to be the better performers over time?
(Related: Not All Active Managers Are Poor Performers)
It's a key question for any advisor who doesn't want to invest exclusively in passive funds, and two recently released reports can potentially help them make that decion — one focusing on U.S. stock equity funds and the other on international stock funds.
Actively Managed U.S. Equity Funds
Scott Opsal, director of equities at Leuthold Weeden Capital Management, writes in a recent report that actively managed large-cap blend funds — defined by Morningstar as funds that combine growth and value but aren't dominated by either — have a much greater chance of outperforming over the long term when average market returns are low or negative.
For example, three-year rolling returns from December 1975 through June 2017 show that more than 60% of actively managed blend funds beat their index counterparts when average annual market returns were 5.6% and 68% outperformed when returns were negative, but less than 40% outperformed when average market returns were 20%.
"Active fund outperformance is unmistakably linked to market outcomes," writes Opsal.
He also found that actively managed fund performance tends to rise when stock valuations are falling, and to fall when valuations are rising, which doesn't bode well for the current market.
Opsal explains that active managers are "valuation aware," so they tend to hold off buying when stock prices are rising to higher and higher levels, which passive index funds cannot do because they move with the maket. As a result, active managers usually don't perform as well as market indexes. But when prices are falling to levels considered good buying opportunities active managers can buy stocks selectively, while index funds will depreciate along with the market.
Valuations are currently high despite the recent mild retreat. They've risen almost steadily since the 2009 market bottom to about 24x on a 12-month trailing basis, "a level and trend that is distinctly unfavorable for active managers," writes Opsal.
Despite valuations, advisors from independent broker-dealers, wirehouses and RIAs invested $51 billion of net new assets into actively managed funds in the first half of this year, favoring the less expensive institutional shares, according to Broadridge Financial Solutions. In addition, self-directed retail investors deposited $36 billion of net new assets into actively managed funds vs. $31 billion into passive index funds, according to Broadridge.
Whether a fund outperforms or not is also a function of the index against which its performance is measured. Opsal found that the choice of a mainstream large-cap index can impact an active fund's "win rate" by almost 15% on average and sometimes by more than 39%.
