Mutual funds: Active or passive?
NEW YORK – To some it is a rivalry for the ages, akin to the one shared by the Yankees and the Red Sox or those who debate whether their beer’s most important attribute is that it tastes great or is less filling.
As with any storied contest, the claims of the stalwarts on either side often draw the most attention. So the long-running debate over whether mutual funds managed by professionals are any better than those that simply mirror major market indexes can obscure a larger point for many investors: Neither side has to be right all the time to be a right fit.
Last year, both strategies, often referred to as active and passive investing, had their moments. But the contest mostly came down in favor of index funds in 2006.
Mutual funds that mirror large- and small-capitalization indexes outperformed a majority of managed funds last year, figures from Standard & Poor’s Corp. show. The Standard & Poor’s 500 index – a widely used benchmark for funds – beat 69.1 percent of managed large-cap funds, while the S&P SmallCap 600 index showed a greater return than 63.6 percent of managed small-cap funds, according to S&P. Among midcap funds, however, managers beat their benchmark, with 53.3 percent of managed funds outperforming the S&P MidCap 400 index.
“Stock picking skills can easily be swamped by a strong market movement,” said Andrew Clark, an analyst at Lipper Inc. “It becomes difficult to beat your benchmark because everything is going up.”
The S&P 500 did better than large-cap funds by more than 3 percent and the S&P SmallCap 600 beat small-cap funds by nearly 2 percent. Actively managed midcap funds topped the S&P MidCap 400 by 0.34 percent.
For the past five years, the S&P 500 has beaten 71.4 percent of large-cap funds, while the S&P MidCap 400 has outperformed 79.7 percent of mid-cap funds. The S&P SmallCap 600 has done better than 77.5 percent of small-cap funds.
Clark notes that in the first half of 2006, before the stock market began its months-long run-up and the Dow Jones industrial average climbed to new highs, some managed funds held the upper hand because portfolio managers made some defensive moves as the market meandered.
“Indexing is a long-term strategy and it may on occasion test the patience of investors,” said Sonya Morris, an analyst with investment research provider Morningstar Inc.
Clark said long-term investors need to remain disciplined and not react to every jump or pullback in the market when investing in index funds. “You’re getting a greater return but you’re also going to pick up a little more volatility if you stay entirely on the passive side.”
Morris noted that index funds and most actively managed funds were burned by declines at the start of the decade when stocks spiraled amid an economic recession.