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What’s the Value of Active Management?

In the aggregate, the value of active management is zero by definition–if somebody is outperforming the market, it’s only because somebody else is underperforming.

But there are times when you have no choice but to make an attempt at answering the question, “What will this fund’s active management be worth?”

For example, what if your retirement plan at work gives you access to two international stock funds: One is a not-particularly-cheap index fund. The other is an actively managed fund that costs just 0.05% more per year than the index fund.

  • Is it worth paying that little bit extra for active management?
  • What criteria should you use for making the decision?
  • And what if the costs were exactly the same? (Or what if the actively managed fund actually cost less?)

People ask me about this scenario (or similar ones) from time to time, and I don’t have a very good answer.

My first response is to go with the fund that’s likely to have the lowest portfolio transaction costs (portfolio turnover being the best indicator of such costs, as far as I’m aware). But if there’s no meaningful difference there either, I’m at a bit of a loss in terms of what to suggest.

The most obvious things to look at–past performance and tenure of the fund’s manager–have both been shown to be nearly worthless as predictors of long-term future performance. (At least, that’s what every credible study I’ve read has indicated. If you’re aware of one indicating otherwise, please share.)

I’d love to hear your thoughts: When given the choice between an actively managed fund and an index fund with similar costs, how do you choose between them?

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  1. Are there fund managers skilled enough to beat the market long-term after expenses and taxes? Yes, I think there are. But the problem is identifying them and knowing the difference between skill and randomness. The handful of funds I own outside of indexes are all value funds, with low expense ratios, moderate turnover, stability in management, consistent investment philosophy and discipline, and luckily haven’t suffered from asset bloat. They’ve handily beaten the market over the past 15 to 20 years, and got through the financial meltdown with significantly lower losses than the average fund or index. The key is they rarely have a losing year, but are so boring they don’t attract a lot of attention to themselves. I would never buy a growth fund. They run off of momentum, not intrinsic value, and tend to flame out, then crash and burn along with their star managers.

  2. In Unconventional Success, David Swensen talks about some investor-friendly characteristics to look for in an active fund: “…courage to hold concentrated positions, to commit substantial funds side-by-side with shareholders, to limit assets under management, to show sensitivity to tax consequences, to set fees at reasonable levels, and to shut down funds in the face of diminished investment opportunity.”

    In addition to looking for these attributes in the active fund, here are a few things that I’d consider when making my choice:

    1. Structure of the active fund company. I would like the active fund to be managed by a privately-held, independent company. Otherwise, there are many conflicts of interest/people to please, making it even more difficult for an active manager to be effective.

    2. The index fund’s expense ratio relative to “normal.” As stated in the post, for this situation to occur, the index fund would most likely have a high ER relative to other index funds in its category. Just how high is the ER? 2x normal, 3x normal? I would look more closely at the index fund company – do they have a history of putting investor interests first, is there a logical explanation for the high ER, etc. If, for example, we’re talking about small-cap US stock funds, and each fund’s expense ratio is around 0.85%, well, that might cause me to lean heavily toward the active fund (to compare, Vanguard’s Small-Cap Index Fund ER is 0.28%…that’s a 3x difference).

    3. My investing philosophy. If I’m a buy-hold-rebalance investor, my risk-appropriate allocation becomes much harder to maintain when an active manager has enough leeway to move in and out of concentrated positions, or to hold substantial amounts of cash. Do I want to introduce manager risk into my otherwise strategically-allocated portfolio?

    4. My desire for a hands-off approach. It takes some work to periodically check up on mutual fund managers and ensure that they still exhibit the investor-friendly characteristics mentioned above. Do I want to take on that burden?


  3. All other things being equal (they rarely are), I would opt for the index fund because with active managers you have such a great tendency for style drift, sector bets, and the like. High expense index funds somewhat defeat the purpose, but at least you can be reasonably sure they will remain fully invested and not stray from their mandate. Make sure you read the prospectus on any fund, including index funds, as names can be deceiving and funds can dramatically change course depending on the leeway their charter allows.

  4. I agree with John. Suppose it’s a perfect world where the index fund and an actively managed one are identical in every way, at least, historically. The actively managed ones always have the possibility of drifting one way or another, which in itself may be a good (or bad) thing. But I would rather that the fund remain index-like, so I’d go with the index.

    The only question, then, is how much cheaper would the actively managed fund have to be before I would buy into it. Fortunately, I haven’t been in this particular situation, so I get to defer my answer to someone who has.

  5. I agree with John and Anthony.

    If nothing else you know what you are getting with the index fund whereas an active fund could be investing in anything.

    From a risk perspective, the managed fund could be a lot riskier than the index fund – or it could be less risky – you just don’t know.

  6. I’ll take the lowest cost fund which will always be the tracker fund. What would I do if the actively managed fund had lower fees? Well it will never happen so I don’t even have to consider an answer.

    Where I personally though think additional performance might be possible is via asset allocation. I therefore build my strategic retirement investing asset allocation from trackers wherever possible but then apply a tactical allocation to the trackers to increase or decrease weightings depending on a valuation model that I am working to.

  7. “What would I do if the actively managed fund had lower fees? Well it will never happen so I don’t even have to consider an answer.”

    It actually does happen. It’s not common of course, but it’s not unheard of. (Ex: Some employers offer a self-directed account option within their 401k. That would allow access to ETFs, but depending on circumstances the total costs may be more than the active funds available in the plan.)

    Would you be willing to pay more for passive funds? (And if so, how much?) I have a very difficult time answering that question myself.

  8. That sounds quite interesting and is certainly a new concept for me. Here in the UK it just doesn’t occur as far as I know.

    Would I pay more for passive funds. I don’t think so. I’d probably take the active option, minimise fees and maximise compound growth working on the assumption that the active fund would over the long run generate average returns. Big risk of course is that the fund manager is incompetent and given what the world has been through over the past few years it’s clear that there are plenty of incompetent people working in banking and finance today.

  9. Would I be willing to pay more for index funds? Probably not. I might be convinced if all my other funds were passive, and I wanted to maintain 100% control over my allocation. But the decision would be out of principle, convenience, or academic elegance, not based on expected return maximization.

    In a world where index funds had no cost advantage over actively-managed funds (across the board), I would probably own index funds only in a taxable accounts.

  10. I’ll go for the index fund in that case. Why? Because I know what I am getting: no underperformance risk. My long-term return can’t be expected to be better, and I certainly can’t expect returns to always be better along the way. Therefore, I know my risks will be greater. Greater risk without a greater expected return for only 0.05% percent more?!? Where’s the value in that? Thanks, but no thanks.

  11. I should say: no significant underperformance risk.

    Mike, what happened to the ability to edit comments?

  12. @RetirementInvestingToday

    Ah, sorry. I forgot you were a UK investor.

    Here we have a few, well, interesting scenarios that can be created as a result of Human Resources employees being the ones who pick the company to run the 401(k).

  13. Hmm…Good question. The plugin is still activated, so I’ll have to look into why it’s not showing up. Thanks for bringing it to my attention.

    And I’m in agreement that I’d be willing to pay a slight amount more to avoid manager risk. That said, I’d be hard pressed to put a number on that amount. Further, I think it might vary depending upon who the manager in question was–I’d probably be more willing to accept manager risk from Wellington than from Fidelity.

  14. I don’t know how much more I’d be willing to pay either, just that I wouldn’t pay even a penny more, let alone 5 bps for manager risk.

  15. Another vote for the index fund. I do hold some actively managed closed-ended UK funds (investment trusts) but I’ve specifically hunted them out.

    If I was given a choice between an index fund or a take-it-or-leave it active fund plucked by some pension manager from the thousands out there on who knows what grounds, I’d go passive in a flash.

    Average minus costs would do me fine in a situation where I have zero control!

  16. I like the lower cost alternative but would take a look at how the sector has performed. The periodic table showed at the end 2008 the international sector down 43%.
    To me this could represent a situation where an active manager could find a lot of good bargains and I might tend to go with the active manager and take a chance. I have to say I don’t have any evidence showing that active managers do better after their sector has done poorly.
    Also I have never seen an index fund offered at a higher price than an actively managed fund. I would go to human resources and point out that we need to ask the provider what the heck is going on.

  17. A different Anthony from the one above.

    I worked for a law firm whose provider, American National Bank, “improved” the 401k by dropping its administrative fee, but changing the funds offered to more expensive options. For one who thus saw the index option get more expensive (net of both ER and admin fee) and less transparent (change from a Vanguard fund to a bank proprietary unit investment trust), I was less than amused. Alas, the partners were unsophisticated enough to see they’d been hoodwinked. But the index option remained the cheapest in the plan by far.

    For me, the question would depend on which index and fund. For US large blend, I’m unaware of an index that would give me pause, so I’d only opt for the active fund if it were cheaper (including transaction costs). But for US small-value, international, real estate, and bonds, I can imagine a scenario where the index tracked bothers me enough that I might opt for the right active fund.

    Asset-class purity and concentration (country, sector, and security) concern me. Certain small-value indices contain enough REITs and/or mid-caps, for example, that I might look more closely at the competing active option. Certain REIT indices are so concentrated in the top five holdings that I might do the same. Bond index funds depend so much on sampling (and sometimes derivatives), that the specifics of the fund’s management could drive me to the active.

    If I had issues with the index fund offered for the targeted style or asset class, I would then use Bogle’s criteria for active fund selection (available here). Also, I just won’t buy a fund with an ER greater than 1.0%.

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