Investors who are looking to invest in mutual funds face the decision between actively managed and passively managed funds. Actively managed funds look to select among potential components of a fund, for instance one selected basket of stocks versus another. This might seem to be a real advantage at first glance, but it doesn’t usually work out to be in practice.
If we were looking to manage a small or modestly sized portfolio, and had the skill and resources that mutual fund managers tend to have, it should not be that much of a challenge to beat the market, in other words to have one’s choices basically beat a random selection.
However, this is difficult to do with the mega sized portfolios that mutual funds manage, where many handle several billion dollars’ worth of money. When you take a position of the sizes that mutual funds do, you can’t just buy and sell like individual investors do, turning around positions on a dime, and this leads to a lot more slippage than one would get if one could just click in and out of positions at the market.
Actively managed funds also have higher management costs, as their costs of trading tend to be higher as well as their having to pay more for top talent, as opposed to passively managed funds which cost considerably less to manage and do not involve any decisions at all beyond just mirroring an index.
When investors choose funds to buy, they need to look at longer term results, not just the last year or two, as certain funds may have been lucky over a shorter period of time. As a general principle, since most funds don’t beat the market, it’s better to hedge your bets and just go with an index fund, preferably one that mirrors broad indexes such as the S&P 500.
The S&P 500 is the king of indexes, and while management fees won’t have you mirroring its performance exactly, management fees with index funds are pretty low so you can come pretty close. Some index funds have lower fees than others so it pays to shop around.
It is also important not to pay any additional fees beyond a mutual fund’s management fees, such as loads or other fees tacked on. Although this has fallen out of fashion a lot lately, some funds do still charge these additional fees. You need to both be able to buy and sell with no additional fees involved.
Actively vs. Passively Managing Your Funds
If someone invests in mutual funds, they are long the markets that they are investing in, the stock market for instance, or the bond market, or often both. The predominant strategy is just to buy and hold mutual funds, and only sell them when you need the money, in retirement for instance or when another major event occurs that requires you cash in part or all of your funds.
This is considered passive management, and is actually no management at all, because the decisions to buy and sell are not related to market conditions at all. Active management involves market factors influencing one’s buy and sell decisions, where the idea is to look to better optimize one’s investments over and above whatever long term return they may deliver.
Passive management exposes us to whatever return the market delivers over the time period that we are holding our mutual funds. While we may increase this performance by moving from one fund to another, we can also fail to achieve as good of a return as a passive style would, and potentially do much worse if we’re not careful and skilled enough.
Actively managing one’s investments properly does not mean just switching funds, in spite of what many people think. Your advisor will of course tell you that switching funds is not a good idea, although while advisors tend to be biased toward your just keeping things the way they are. While they often do not provide good advice, in this case not jumping around funds is a good idea indeed.
There actually isn’t that much difference between funds from a fundamental perspective. Sure, a fund may pick some better stocks over a period of time, but this doesn’t mean this will continue. If anyone could pull that off, if certain funds were actually that good, they would dominate the market.
What tends to happen when you jump funds is you end up going with what’s hot at the time, which usually cashes out to the funds who have been lucky lately, but this luck doesn’t always continue, and it can turn out that the fund you left ends up doing better than the one you chose instead.
In any case, this tends to be substituting one substantially similar investment for another, and while this does not mean that there is never a reason to switch funds, chasing the hot funds doesn’t usually tend to add much to one’s returns overall, and can have the opposite effect.
Managing Your Asset Class Allocations
A more meaningful way to actively manage one’s funds is to manage one’s asset class allocation actively. Advisors suggest that one’s asset class mix should be based upon a number of conditions, but unfortunately, how particular asset classes are doing isn’t one of the factors that gets recommended generally.
So, it’s not so much whether you are in this fund or that fund when the two funds are similar, as this does not tend to make that meaningful of a difference in performance. What you are investing in with your funds is a different matter though, and this is what we need to be focused on if we’re really looking to actively manage the performance of our investments.
The three major asset classes that mutual funds deal in are growth, income, and savings. The growth component consists of investments in common stocks, the income component is made up of bonds and preferred shares, and the savings component consists of money market funds as well as other savings vehicles.
Market performance is far from random, and if it were, there would be no point in investing at all, because the expected return would be zero. Few people believe that investments are random walk because this isn’t what our history with them have been, and they do tend to produce a positive expectation over time.
While the long term trend is expected to be positive, there are other trends of various lengths that emerge. Some of these trends are up and some are down, which we call bull and bear trends and markets.
The optimal way to manage mutual fund performance is not to select a certain asset allocation solely based upon personal factors such as time horizon, risk tolerance, investment objectives, and so on, we also need to be accounting for the performance of the assets themselves, and in particular, their relative performance.
There are times when, for instance, the stock market is in a down trend, but bonds may be doing well. Perhaps both stocks and bonds are bearish, but savings are never really bearish, as they generally produce a positive return, and one can get a guaranteed return in fact with things like certificates of deposit.
Actively Seeking to Manage Allocation Based Upon Performance
While no one cannot predict with accuracy the performance of any asset, this does not mean that we are limited to throwing up our hands and not bothering to manage our asset allocation actively.
Assessing and predicting market performance is all about seeking out probabilities, and if we know that a certain thing is more likely to happen than not, this is enough to represent an advantage to us. If we know, for instance, that an asset is likely to go up two thirds of the time and likely to go down one third of the time, it makes sense to bet on it going up rather than down.
As it turns out, there are trends that develop with the performance of assets, particularly with stocks, that are not difficult to ascertain and act upon. Performance not only follows business cycles, these trends take on a life of their own and are self sustaining as people move money in and out of assets over time.
Markets going up, when we see influxes of capital, tend to drive a greater influx of capital. Money out flowing from assets also tends to produce more outflow as more people look to lock in their profits or avoid seeing their positions go against them even more.
Income based assets are also fairly easy to predict with the amount of accuracy we require, which once again is simply a balance of probabilities, as interest rate trends tend to be well established and income assets follow interest rates.
The savings category is the default, where neither growth or income assets are more likely to go down rather than up, and whenever that is the case, holding these assets is simply a bad bet. Casinos make fortunes based upon very small advantages, and the advantages that are present in assessing market conditions are significantly greater.
When we place bets in a casino, we know that the expected return of these bets is a negative one, but we hold positions in mutual funds all the time with much worse odds and think nothing of it.
If we convince ourselves that none of this is knowable, that we cannot be sure enough of the direction of a market to make any decisions and be right more than we’re wrong, then we’re going to be stuck not managing our positions at all and have to settle for whatever fate brings us.
Perhaps fate will be reasonably kind over the very long run as it has in the past, but if this involves what amounts to placing bets when the odds are against us, and we can reasonably tell when this is the case, we aren’t doing ourselves our our investments any favors by just trying to ignore all this.
Looking to actively manage one’s asset allocation certainly isn’t for everyone, and does require that we take ownership of our portfolio in a way that many are not comfortable doing, but for those who are up for it, this can present a significant advantage in seeking better returns with one’s mutual fund portfolio.