Why It’s Time to Consider Actively Managed Funds

The debate between passive and active fund management is one of the great investing controversies.

Passive index fund investing seems to be winning the competition. Recent Vanguard research found that since the 1976 index fund inception, the majority of passively managed index funds outperformed their actively managed competitors. Although, part of the outperformance can be explained by the lower fees typically charged by index funds.

Vanguard, the indexing leader, notched $19.7 billion inflows in 2018 and $6.9 billion in January 2019.

For passive fund investing, index fund investors buy shares of mutual or exchange-traded funds that follow an investment strategy of owning the investments in similar proportions as those in an unmanaged index such as the S&P 500 or the Nasdaq composite.

But it might be time to consider actively managed funds. There are sectors, industries and fund managers that claim to beat the indexes. Now, after a 10-year bull market, with increased chances of losses in market indices, might be the time to seek out actively managed funds.

“The intention of active management is to outperform a passive market index benchmark," says Mark Eibel, director of client investment strategies at Russell Investments in Seattle. Active management leverages all the tools available to achieve better returns than index fund investing. Investors who miss out on active management run the risk of missing out on the potential for outperformance.”

Here are a few reasons to consider active management for your portfolio strategy:

Areas Where Active Management Works

Specific corners of the market have greater chances of beating the market.

Chris Faber, portfolio manager at RMB Capital in Chicago explains a strategy to find actively managed funds that outperform indices with a measure called Active Share. Researcher Martijn Cremers and colleagues define active share as the percentage of a portfolios holdings that differ from the benchmark index holdings. Their research found that a high Active Share predicts an active fund manager's outperformance.

In addition to the high Active Share predictions, there’s a consistency among professionals regarding asset classes that can outperform the market indices.

Morningstar’s Active/Passive Barometer research found that three times as many actively managed emerging markets stock funds beat their benchmarks over the past 10 years in addition to the actively managed large-blend U.S. stock funds category.

Faber claims that active managers add value in small-cap assets where there tends to be less liquidity.

To find the active managers that beat passive index funds, it’s best to look at the small-cap, mid-cap, international and specialty areas of the market, says Peter Creedon, CEO of Crystal Brook Advisors in New York.

Since 2009, T. Rowe Price QM U.S. Small-Cap Growth Equity (PRDSX) has generated a 10-year return of 17.45%. In contrast, the Vanguard Small Capitalization Growth Index Fund Investor Shares (VISGX), which benchmarks the small-cap growth index, returned an average 15.94%. The actively managed fund versus index in this instance outperformed by about 1.5 percentage points.

Many investment professionals, including Robert Reilly, chief investment officer at Sandy Cove Advisors in Massachusetts, believe that actively managed bond funds can handily beat bond index funds. In fact, the DoubleLine Core Fixed Income Fund (DBLFX) has gained an average 3.18% annual return over the past five years. That's in contrast with the 2.94% index fund return of Vanguard Intermediate-Term Bond Index (VBIIX).

Actively Managed Fund Fees Are Declining

Index fund investing lures investors with rock-bottom fees. Every cent that goes toward fund management is subtracted from investors’ returns. So it stands to reason that lower priced funds start out with an advantage. In a race to the bottom, Fidelity Investments recently launched Flex funds, a slate of zero-management fee index funds including the Fidelity Flex 500 Index Fund (FDFIX) and the Fidelity Flex Small Cap Fund (FCUTX).

Joining the fee lowering cohort are many actively managed funds. Morningstar reported last year that management fees in all categories of actively managed funds declined. Mathematics implies that lower fees, such as those for cheap mutual funds, give fund managers a shot at higher returns.

While indexing in general beat active investing over the past 10 years, the funds with lower fees outperformed the more expensive ones.

The Rise of Actively Managed Robo Advisors

While most digital investment managers adhere to a passive index-fund investment approach, there are a growing minority of low-fee digital investment managers.

Legacy digital investment advisor, Personal Capital uses a unique investment management approach. But there are several newer robos with active management, too.

Former hedge fund managers are at the helm of these two actively managed robo advisors, qplum and Elm Partners. Mansi Singhal, co-founder of qplum, and Victor Haghani, founder of Elm Partners, are taking their investment expertise to the masses, with proprietary automated active management investment strategies. The qplum strategy, is built with artificial intelligence models that account for your risk tolerance and move in and out of the markets depending on specific indicators.

Elm Partners, the lowest fee actively managed robo advisor, invests in low-fee index funds. This robo advisor incorporates investment research into its approach and marries value and momentum investment strategies to capitalize on various market conditions.

Personal Capital and Elm Partners require higher minimum investment amounts. Elm Partners, for instance, requires a minimum investment of $300,000 for individual accounts. For those seeking active management with a lower minimum, qplum will manage your retirement account with only $1,000 or a minimum $10,000 for a taxable investment account such as an individual retirement account. The management fees for these robo advisors ranges from 0.12% per annum for Elm Partners to 0.89% at Personal Capital for the first $1 million, with a monthly bill.

While newest entrant, New York-based Titan, a recent graduate of the Y Combinator recently launched a robo advisor with a hedge fund approach for actively managed funds.

The Titan approach is unique for an app-based robo advisor. They choose 20 stocks with strong cash flow, low competition, high return on capital, excellent management and strong growth prospects. Then they tilt the portfolio in accord with your risk tolerance. Titan uses software to automate and track other hedge funds investing, as reported in public records. Since hedge fund investing is speculative and the 1% management fee is on the high end, investors should proceed with caution, despite the $500 minimum investment requirement. A small position is best for more conservative investors.

With current jumpy markets and an uncertain global economy, now might be the right time to give the active managers a try.