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Evaluating the value of using active management

Do you want a portfolio manager to pick emerging markets stocks for you? High-yield bonds? Alternative investments?

The massive move of assets from actively managed portfolios to passive funds that track an index hasn't happened in every corner of the investment landscape. In markets, where the differences between winners and losers is greater and the information available to the public is less available, there's still a broadly held belief that investors may be better off with active investment management as opposed to buying an index fund.

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"It's never easy to outperform, but in markets that are less efficient with less-perfect information, people perceive it to be easier," said Tim Cohen, a chief investment officer with Fidelity Investments, one of the biggest active asset managers in the country. "Where there's a wider dispersion of returns and less correlation between them, there's more opportunity to beat the benchmark."

It seems to hold true for markets such as small-cap stocks and international equities. The average active fund manager in those asset classes beat his or her benchmark by 86 basis points in the case of large-cap international equities, and 111 basis points in the U.S. small-cap sector, from Jan. 1, 1992, to Dec. 31, 2014, according to data from research firm Morningstar.

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In more efficient markets such as U.S. large-cap stocks, however, about 1 in 5 active managers beat their benchmark indexes, and money continues to shift to passively managed funds. It's in the less liquid, less well-understood markets that having a professional manage the portfolio may be a better strategy for investors.

That is, at least, the argument for using more expensive active management of investments. The high-yield bond market, for example, would seem to be a sector where picking securities would be at a premium and where active managers have more room to beat the market. With the energy and mining and material sectors accounting for more than 25 percent of total issuance in the market, the index has been hammered by the collapse of oil and other industrial commodity prices.

"There's a perception that less-efficient markets are better for active managers, but in every market, it's a zero-sum game of performance. For every overweight position, you have an underweight." -Jim Rowley, senior investment analyst with Vanguard Group

The BofA Merrill Lynch US High Yield Index has dropped from a peak of 1091 this year at the end of May to 1020 as of Oct. 1. Yields have risen from under 6 percent in late April to 8.14 percent on Oct. 1, and the spread with comparable duration Treasury bonds increased from 3.35 percent in June last year to 6.67 percent as of Oct. 1. If an active manager had avoided the energy and metals sectors for the last year, they would clearly be outperforming their benchmark.

Jim Rowley, a senior investment analyst with Vanguard Group, doesn't buy the argument. "There's a perception that less-efficient markets are better for active managers, but in every market, it's a zero-sum game of performance," said Rowley. "For every overweight position, you have an underweight.

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"Someone is on the right side of a trade, and someone is on the wrong side," he said. "The collective average performance of managers can't be better than the average."

Rowley said that is true of markets with wider dispersion of returns, as well. The opportunity for more significant outperformance by the top managers may be better, but the odds of beating the index are equally poor, and when you factor in the higher fees and execution costs of active funds, the picture gets much worse.

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He suggested that if investors want to chase outperformance, they take a good look at their active manager and a good look at themselves.

"The best predictor of long-term performance is the expense ratio," Rowley said. "If you start with low-cost funds, the hurdle for outperforming is lower."

Rowley also suggested that investors have to commit to their managers and not bail during periods of underperformance.

"Outperformance comes with bumps in the road," he said. "You have to believe in the long-term opportunity."

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The value of active management may still be substantially greater in the fixed-income market. In part, that's because of limitations with the indexes tracking market segments, according to Ben Johnson, director of global ETF research at Morningstar.

The Barclays Capital Aggregate Bond Index, which serves as the benchmark for most intermediate bond fund managers, doesn't include high-yield bonds or dollar-denominated emerging markets debt. "It doesn't reflect opportunities across the bond market," said Johnson. "The breadth of investments for some benchmarks can be limited."

Active bond fund managers have consequently fared better versus their benchmarks than equity managers, and retained a much higher proportion of assets in the industry. At the end of July, active bond fund managers accounted for 76 percent of assets in the asset class, compared to 61 percent in the U.S. equity fund market.

The same benchmarking issue also applies to alternative assets. While most of the liquid alternative asset funds that have come to market since the financial crisis employ active hedge fund–like strategies, there is not yet a good benchmark for comparing them, let alone "passively" investing in them.

The famously opaque hedge fund industry is certainly not interested in helping create one. "The alternatives space is a completely different ball of wax," Johnson said. "What's the appropriate benchmark?

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"It's difficult to get a true assessment of winners and losers in that space."

While active fixed-income managers may continue to attract the majority of assets going into bond funds, the ETF and index fund manufacturers have their sights trained on the more than $3 trillion fixed-income market.

Johnson expects them to come up with better solutions to make passive investing in bonds a more attractive prospect. "We'll see a lot of money and energy put into developing better bond indexes for investing," he said.

By Andrew Osterland, special to CNBC.com