I am a die-hard index fund advocate. Yet, there are times actively managed mutual funds make sense in a portfolio. No, this isn’t April Fools’ Day and I am not going senile. There happens to be situations where a low-cost actively managed fund does a better job than an index fund at capturing the return of an asset class or capturing a unique risk within an asset class.
Before getting into details, I’ll first explain my methodology for selecting investments for a portfolio. It begins with deciding when an asset class or risk factor is appropriate. The following is a summary of a framework for investment selection as written in Chapter 5 of my book, All About Asset Allocation:
Potential asset classes for inclusion in your portfolio should have three important characteristics:
- The asset class is fundamentally different from other asset classes in a portfolio.
- Each asset class is expected to earn a return higher than the inflation rate over time.
- The asset class must be accessible using a low-cost diversified fund or product.
Fundamentally Different: Asset allocation is risk diversification. In order to have risk diversification, each investment in a portfolio must be fundamentally different from other investments. This gives the portfolio an assortment of unique risk characteristics, which can play off each other. The first criterion for selection is that an investment under consideration must be observably different from all other investments. This is done using a variety of methods that are outlined in my book, including correlation analysis.
A Real Expected Return: Every asset class I select is for long-term investment, and this means it must be expected to earn a return greater than the inflation rate. Securities that do not keep pace with inflation or only keep pace with inflation are not considered. Although some discarded investments may help lower the overall risk in the portfolio, it would be at the detriment of owning fewer investments that generate a real return. Lower risk may be OK conceptually, but you can’t eat it in retirement.
Accessible at low cost: An asset class that is being considered for inclusion on your investment list must be “investable” at low cost. This means that there are liquid and diversified marketable securities available that can be used to acquire the asset class. Look for mutual funds that have broad holdings, low expense ratios and no redemption fees.
Nowhere in the above outline do you read that an index fund is required in every asset class. I do prefer index-tracking, “beta-seeking” mutual funds and exchange-traded funds (ETFs) because their expenses are low and because indexes are normally used to conduct the asset class analysis. However, on some occasions, no-load actively managed mutual funds are acceptable substitutes. Here are a few circumstances when I consider an actively managed fund over an index-tracking product:
- The absence of a diversified low-cost index fund or ETF that tracks the asset class.
- An active fund is lower in cost than an equally diversified index fund.
- An active fund has greater diversification than an index product, even if the fee is slightly more.
- The unique risk I am trying to capture is better suited to active management than in an index-tracking product.
Next are a few examples of when I have used an active fund rather than a beta-seeking index fund or ETF. I’ll address these investments in general terms rather than trying to name every fund.
Municipal bonds: The tax-exempt municipal bond market is fragmented, localized and often has liquidity concerns. This creates an environment where the rigidness of tracking an index may be more of a burden than a benefit. There are some low-cost municipal bond ETFs that have enough volume to work around the issues of this market; however, a broadly diversified and low-cost actively managed municipal bond fund that doesn’t need to track an index is often a better alternative.
High-yield corporate bonds: This asset class suffers from the same fragmentation and liquidity issues as tax-exempt municipal bonds. This also creates an environment where the rigidness of tracking an index doesn’t work well. There are several low-cost high-yield corporate bond funds available; however, a broadly diversified and low-cost actively managed high-yield fund may be a better choice.
Value stock strategies: This isn’t really an asset class; it’s an investment in a risk factor. There are many different ways to implement a value strategy. Value stock indexes slice larger cap-weighted indexes into style components. Fundamentally weighting is a quantitative strategy that overweighs value stocks in an index. Pure quantitatively methods are used to manage value stock funds that do not follow indexes, such as those offered by Dimensional Fund Advisers (DFA). Finally, there is full active management where a fund manager picks companies that they believe have value characteristics.
Currently, I am using a few actively managed bond funds and value stock funds. I blend a combination of cap-weighted value index funds and DFA funds. That’s not to say there is anything wrong with using fundamentally weighted index funds or even full active management. It’s a matter of cost relative to the strength of the value factor you’re seeking.
I hope I was able to show where actively managed funds may make sense in a portfolio. I’m still an index guy at heart, but it’s also true that select low-cost and broadly diversified active funds have been an important part of my portfolio allocation for a long time.