If you’re concerned that the long bull market run is winding down or that the recent rise in interest rates will continue, or if you’re apprehensive about the uncertainty of a new administration, this may be the time to consider switching from index funds to actively-managed funds. While past performance is no guarantee of future results, as the Thrivent Mutual Funds Active vs. Passive Study demonstrated, the no-load actively-managed funds in the study have done a better job of limiting losses than their corresponding indexes during the recent bear markets and volatile market stretches.
To achieve even greater diversification, investors may consider actively-managed asset allocation funds, which offer broad diversification across multiple asset classes. While diversification does not eliminate risk, it generally helps reduce losses during steep stock market declines.
Here are several other reasons to consider switching to actively-managed funds:
- Flexibility. Some managed funds have done better than index funds during down markets due, in part, we believe, to the fact that fund managers have had the ability to make some adjustments in their portfolios to reduce the stocks or sectors that appear the most problematic. Investment managers can also use risk management techniques and diversification that seek to provide similar returns to the market with lower risk and volatility.
- Help when needed most. A rising tide lifts all boats. Ever since the Federal Reserve launched quantitative easing activities intended to stabilize the economy and lower interest rates, all of that extra capital in the system has flowed to equities across the board, boosting market returns while greatly increasing correlations among stocks. That means that all equities, even stocks that many active managers think are unattractive, have generally gone up together, with higher risk companies that carry more debt on their books actually leading the way as the low interest rates have distorted the risks inherent in holding too much debt.
- That’s been an advantage for index funds, since they own all equities, even those presumably “higher risk” stocks that active managers are avoiding. But while an index fund may (or may not) offer better returns in a bull market, active managers tend to provide their greatest value during bear markets when investors need their help the most. Normally, and particularly so in bear markets, stocks experience a wide variety of rates of return, meaning that index funds will be exposed to both the good performers and the bad, while active managers have a better opportunity to avoid those bad performers.
- A better chance to beat the market. The fact is index funds perpetually trail the market by a small margin. Their costs, while minimal, create a small differential between the market performance and their own returns. As the study demonstrates, in any given year, actively-managed funds can, and have, outperformed the market.
- Active funds have responded by lowering fees. Actively-managed mutual funds have responded to the low fees of index funds by lowering their own fees over the past 20 years. According to the Investment Company Institute, the average equity mutual fund expense ratio was 1.08% in 1994 and dropped to just 0.68% in 2015.1 The lower fees would add, on average, about 0.40% per year to the returns of actively-managed funds. With all other expenses remaining the same, in general, lowering fees results in an increase to the total returns of equity mutual funds.
- Limiting market losses can speed up your recovery. Actively managed funds may not always cut your losses, but if you are successful in reducing your losses in a down market through an actively-managed fund, the road to recovery becomes much easier. In fact, the bigger the loss, the more difficult it becomes to recover from that loss. For instance, for a 5% loss, you would need a gain of 5.26% to restore your portfolio to its previous level. But with a 20% loss, you would need a gain of 25% to get back to even; a 30% loss would require a gain of 42.9% to fully recover; and a 50% loss would require a 100% gain to bring the portfolio back to its previous level.
In terms of pure long-term performance, index funds may (or may not) have a slight edge. But when the chips are down and the markets are reeling, the Thrivent Mutual Funds study suggests that you may be better served to have an active manager in your corner making the crucial decisions.
The tables below summarize some of the key results of the study during the Dot-Com Crash, the Global Financial Crisis and the decade of 2000 – 2010.
The table headings include: Lipper funds category (“large cap core” or “small cap core”), Index (S&P 500 or Russell 2000), the four performance quartiles (the higher the percentage the worse the relative performance), and the Average Percentile Ranking.
The Average Percentile Ranking is not tied to the quartile rankings, and provides a different vantage point on the comparative performance. It measures the average percentile of how they ranked over the given period of time. As with the quartile rankings, a lower percentage indicates better performance while a higher percentage indicates worse performance. For example, in the Dot-Com Crash table below, the average percentage of the S&P 500 was 70.6%, which put it in the bottom 30% among all funds in that category. The Russell 2000 Index fared even worse with an 81.9% average percentage – which means it would have ranked in the bottom 18.1% of funds in the small cap category.
In the following charts, please keep in mind that the 1st quartile represents the best performance and the 4th quartile represents the worst. For example, in the first table entitled “Dot-Com Crash,” you will see “0.0%” in the 1st and 2nd quartiles for each of the two indexes. That indicates that neither the S&P 500 nor the Russell 2000 would have ranked in the top half (1st or 2nd quartiles) in performance in their respective actively-managed no-load fund groups during a single 12-month period from Sept. 31, 2000 through March 31, 2003.