Index vs. Managed Funds: Best Choice Now Could Be Both

Choosing between indexed and managed funds is really no choice at all: Investors who rely solely on one or the other these days are doomed to failure.

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The situation has been a case of pick your poison as index funds are right back where they started after a volatile 10-year journey, and managed funds in risk-adjusted real terms actually have underperformed even that low standard.

So who has been a winner in all this market malaise?

It's been investors who have used smart combinations of both to maximize returns when the market has presented opportunity and protected portfolios when danger has come.

"Investors need to look at this not as a choice of one or the other," says Paul Lebouef, financial consultant for Charles Schwab. "A lot of times a mix of both is perhaps the most prudent choice."

Amid the turbulence of the past years a managed fund historically would be considered the more reliable option. That's because managers have more leeway to hold safe-haven cash and take short positions in a down market than an index fund.

Index funds mimic the performance of a broad range of stocks such as the Dow Jones industrials or transportation averages, the Standard & Poor's 500 or the MSCI Commodity Index and don't have the adaptability to market changes that a managed fund provides.

Yet managed funds have won the battle only 37 percent of the time in the past three years, according to a recent report from Morningstar that emphasizes how not all managed funds are created equal and investors need to shop carefully.

"The fact that the average active fund doesn't beat an index fund doesn't necessarily mean that you shouldn't use active funds. It means you have to set the bar high," says Russ Kinnel, director of fund research at Morningstar. "It's not so much about performance but other fundamentals."

Managed funds actually have measured about even against the indexes over the past five years in total returns, but falter when adjusted for risk. Because of the wild gyrations the market has seen, investors have tended to bail out of managed funds in bad times, thus missing the upside when the market recovers.

"[P]erformance has not been enough to account for the increase in risk taken on compared with the Morningstar indexes," the firm's report said.

Yet the debate over which option is better rages on.

The Quest For 'Long-Term Alpha'

One side contends that investors, particulary those with low risk appetites, will always do better with index funds over a long time horizon.

The other side concedes that investors who aren't on their toes can lose with managed funds, but that with no risk comes no reward. Maximizing "alpha," or the value that a strong manager brings to a portfolio, can only come with active managing, they say.

"The problem with an index fund, which is inherent, is the good index funds are closet momentum funds. They must own the best-performing stocks over the most recent history," says Michael Kresh, president of M.D. Kresh Financial Services in Islandia, N.Y. "You're always going to be owning what was good and never looking forward saying what should be good."


For advisers like Kresh, the rapid flow of information today almost demands that investors be more flexible. Underperforming funds, he says, are victims of the information age and should be avoided.

Conversely, managers plugged into the trends and who demonstrate the ability to move quickly are those who will win.

"The more a manager is open to investments when he sees good value the higher probability that he has long-term alpha," Kresh says. "Those kinds of managers who are flexible managers and look around and say, 'Here's an imbalance'—those kind of managers tend to have legitimate long-term positive alpha."

In fact, the central point of the index vs. managed debate could be the latest sounding of the death knell for traditional buy-and-hold investing.

Indeed, even those who support index funds are increasingly employing a hybrid strategy that entails gravitating toward ETFs that offer many of the same qualities as traditional mutual and indexes but allow investors to be nimble in their positions.

Kathy Boyle, president of Chapin Hill Advisors in New York, had been trading both long and short exchange-traded funds throughout the market's collapse prior to March and found the strategy an effective way to maximize gains while minimizing risk exposure. ETFs generally are not as volatile as stocks and hold a broad portfolio of equities so as to minimize risk should an individual company in the portfolio suffer.

A market bear, Boyle has found the sledding tougher in the past seven months but believes in the general strategy.

"We're primarily using ETFs because we can control the pricing and we can employ them for a certain period of time. If we go into a (mutual) fund we have to hold it for 30 or 60 or 90 days," Boyle says. "If we want to establish a position and we're worried the market could drop, do we really want to be stuck in this fund?"

Investors wanting an active manager should choose carefully, she adds. Boyle says managers her firm has used in the past sometimes talk a good game but don't always deliver on the strategies they say they will employ.

"Part of what we look at is managers and what their sell discipline is. We have found they often vary from what they tell us," she says. "If the manager tells you that they sell when their stocks start to underperform the S&P by 'X,' they better be following it."

In years past investors trying to build a retirement fund were used to paying far less attention to their portfolios. But times have changed, the market has changed, and so has investing.

"Buying and holding still is a very good strategy. However, you cannot buy and forget," Schwab's Lebouef says. "You have to be cognizant that market cycles change, life situations change, risk tolerance changes. It comes back to if you're going to be investing on your own, you have to put in the time."

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