NEW YORK (CNNfn) - There was a time not so long ago when actively managed mutual funds got pummeled on performance charts. But now it's their "rivals" -- funds pegged to indexes -- that are on the defensive.|
Actively managed funds are outperforming index funds by nearly five percentage points in 2000, continuing a trend that started in 1999.
While the shift has re-ignited the debate over the two investing styles, financial advisers say you shouldn't give up on indexing in your long-term investing portfolio.
"Indexing is a long-term strategy," said Scott Cooley, an analyst at fund-tracker Morningstar. "It still makes sense to have a mix of index funds and actively managed funds."
Actively managed funds come in out of the cold
Actively managed funds had been in a long drought until 1999, when they earned 27.50 percent for the year, compared with 20.49 percent for index funds, according to Morningstar. Until then, actively managed funds hadn't beaten index funds since 1993.
And while index funds are down 3.15 percent for the year through Feb. 29, actively managed funds are up 2.95 percent, Morningstar said.
"It's been a cyclical phenomenon," Cooley said. "It's anybody's guess how long this current period of manager outperformance will last."
Index funds soared for years because large-cap stocks drove the market and helped fuel stellar growth in the indexes, Cooley said. Now, mid- and small-cap stocks, more the staple of actively managed funds, are doing well.
Strong performance by technology stocks has also helped fund managers beat the indexes. Many index funds track the S&P 500, which doesn't have many tech names. And actively managed funds can overweight a stock such as Qualcomm (QCOM: Research, Estimates) or Microsoft (MSFT: Research, Estimates) to deliver better returns.
"No matter how many times you yell at people, they're always going to follow what's doing well at the moment," said Reuben Brewer, manager of mutual fund research at Value Line Inc. "Does it mean that investors will go for those really hot tech funds? Yes. Does this mean death to index funds? No. Indexing is still a very valid strategy. Over time, most managers don't beat the index."
Another problem is the S&P 500 has been slow to change. It took the index until December 1999 to add Yahoo! (YHOO: Research, Estimates) to its fleet of stocks, Cooley said. And America Online (AOL: Research, Estimates) didn't join the blue-chip index until December 1998. (America Online is merging with Time Warner, parent of CNNfn.com.)
Indexing gained in popularity in the 1990s thanks in part to efforts by fund giant Vanguard Group and its founder, former chairman John Bogle. Bogle preached for years that index funds had much lower costs and better returns over time.
From 1994 through 1998, only a handful of managers were beating the S&P 500. A manager such as Bill Miller, of Legg Mason Value Trust, took on hero status for his record of beating the blue-chip benchmark for nine years.
But fund experts say indexing inevitably would fall from the top of performance charts.
"In any given market, index funds should beat 60 percent of actively managed funds, not 90 percent like it's been," Cooley said.
What should you do
Some advocates of index funds think you shouldn't be swayed by the shift in returns. Frank Armstrong, a certified financial planner and president of Managed Account Services in Miami, said index funds are pure investments. An actively managed fund isn't held to the same standards, so when he does well he looks brilliant, but he can also look like a goat the minute the market shifts.
"If you put all your chips on 'red 39,' of course you're going to win from time to time," Armstrong said. "Obviously you get periods when active managers look like they're adding value, when they're really just in a different part of the market."
Other experts think there is room in your portfolio for both types of funds. Vanguard recommends about 50 to 60 percent index funds and the rest in actively managed funds, said John Woerth, a principal at Vanguard.
Cooley said a total stock market index fund is a good first choice for beginning investors.
It might also make sense to leave your cost- and tax-efficient index funds in a taxable investment account and put your actively managed funds that can have capital gains in a tax-deferred 401(k) or IRA.
Read Cooley's analysis of how the Vanguard 500 Index Fund outperformed other index funds in 1999.
You might want to use the actively managed portion of your portfolio for investing styles in which a skilled manager can add the most value, such as in international stocks or REITs, Brewer said.
For those who want to add more actively managed funds to their portfolio, they should look for managers with a good long-term track record, Brewer said.
"It's important to understand what the manager is doing," Brewer said. "You should believe in what he's doing. All (investing) styles have dry periods."
Keep in mind, too, that even managers of index funds are doing some work in the margin to add value. Sometimes managers are skilled at investing incoming cash into the fund, or they use futures contracts instead of the stock, or they're good at negotiating trades with market makers, Cooley said.
"Those subtle differences (in returns of index funds) make a big difference over the long term," Cooley said.