Active vs. passive funds? Which way should I go?

This is one of the most common questions I get from my High-Yield Investing readers – especially those who are just joining us.

Typically, we focus on individual securities over at my premium service. But we also give ample focus to a number of funds, typically those that focus on areas of the market that are better suited for a basket-like approach.

Realize that this can be divisive and hotly debated among the investment community.

Both Sides Of The Active vs. Passive Fund Debate

On one side of the active vs. passive funds debate are the folks who fall in the efficient market hypothesis (EMH) camp. They insist that since markets are “efficient,” it is folly to try to beat the market, so save yourself the trouble and invest in a low-cost index fund.

On the other side are those who believe that a well-trained “superstar” manager can deliver superior returns.

You may often hear people bring up the fact that the majority of actively managed funds fail to outperform the broader market. That’s certainly true. According to S&P Global, large cap fund managers had their best year since 2009, with only 51% underperforming the S&P…

Game, set, match, indexers. But not so fast.

Interestingly, the more funds skew toward value (and smaller-cap names), the less likely they seem to underperform their benchmark. I should note that these figures vary widely from year to year. That would support the notion that active managers do better in volatile conditions.

It’s easier to find managers who beat the market for a year or two than consistently do so over the long haul. But they are out there… Bill Miller famously steered the Legg Mason Value Trust to market-beating gains 15 years in a row through 2005.

Or how about Peter Lynch? The legendary money manager annihilated the market when he was at the helm of the Fidelity Magellan Fund (once the largest in the world), racking up annual returns of 29.2%. During his 13-year tenure ended in 1990, a $10,000 investment would have grown to $280,000.

This confounds the EMH supporters. They contend that stock prices adjust quickly and fully reflect the latest information available. That would mean stocks are always priced perfectly, so it’s impossible to achieve excess market returns. I think this is utter nonsense. The fact is, the market is sometimes irrational, driving stocks well below (or above) what they’re really worth.

Here’s My Honest Take

I’ve covered this debate before in a broader context. But I want to address this debate specifically, so forgive me if I’m repeating myself a bit. But here’s my take…

Yes, skilled money managers can identify mispriced securities that are likely to outrun the crowd. These are the exceptions, not the rule. Even Buffett himself endorses passive index funds for some investors. So does Peter Lynch, who once said to forget about throwing darts and just “buy the whole dartboard.”

I’ve been in this business in one way for another for a very long time. I got my start at Morgan Keegan, where I managed portfolio assets and helped clients with retirement planning. And in my personal opinion, I believe that some active managers are well worth the added cost. It’s just a matter of finding them.

But therein lies the rub. Still, you’ll find a mix of both active and passive funds in my portfolio over at High-Yield Investing. And I wouldn’t be writing my premium newsletter if I didn’t believe in taking at least somewhat of an active approach.

The truth is that different situations call for different strategies. If you just want a low-cost piece of a specific sector, then a passive exchange-traded fund (ETF) is probably the way to go. But there are other situations where we need to turn to the pros.

For example, this makes a lot of sense in the fixed-income world. Bonds are a relatively illiquid market, with more pricing inefficiencies to exploit. Same goes for emerging-market stocks. That’s why you’ll typically see a much greater percentage of active funds outperform in these asset classes.

I encourage you to go back and check out that S&P Global report I linked to earlier. You’ll see what I mean if you get past the headline data.

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