Here's the criteria advisers should consider when determining whether actively managed or index funds are right for their clients. Think investor objectives, fund liquidity, safety, guarantees.
Visit the first tee at virtually any golf course, and you'll invariably witness the following scene play out: Dressed to impress and equipped with the newest, hottest set of clubs on the market, somebody will calmly stick a tee in the ground, address the ball and confidently take a rip — only to watch their ball fly deep into the woods. The next 17 holes will unfold in much the same way.
As an amateur golfer, I've seen this many times and the lesson is always the same: It's not the wand, it's the magician. If you're a terrible golfer, it doesn't matter what you wear or the clubs you use, you're still a terrible golfer. You could be wearing overalls and swinging a two by four, and the results probably would be about the same.
The same basic principle applies to helping clients choose the right investment vehicles: Wands have limited value if not wielded by a capable magician.
In the case of our industry, index funds that seek to track the market can be dressed up but they're simply designed to track the market or a particular slice of the market. But it takes seasoned pros who have demonstrated a continuous track record of success to set actively managed funds apart.
For many advisers, one of the key features distinguishing index and actively managed funds is price. Actively managed funds typically cost more, at least nominally. And while there is no doubt that management fees are an important consideration that advisers should cover thoroughly with their clients, it is just one of many factors to consider when compiling a portfolio that is in line with investor objectives.
The criteria that advisers should consider when determining whether actively managed or index funds are right for their clients include investor objectives, fund liquidity, safety, guarantees, fluctuation of principal and/or returns, and tax implications.
That said, it's important that advisers help clients find answers they can live with to the following three questions concerning index funds:
Is there limited upside opportunity? Because index funds seek only to track the market, what are the chances they will significantly outperform it? Logic would suggest that, generally speaking, such chances are relatively limited.
How much protection against downside risk is offered? Financial advisers and the clients they serve need to ask themselves: Are index funds far more vulnerable than actively managed funds when it comes to broad market trends? The very nature of indexing, which involves assembling a broad basket of representative securities, might indicate that this could be the case.
Are there hidden fees involved? If you are already looking at relatively limited upside potential and relatively higher risks of exposure to a broad market downturn, then how low an index fund's fees are becomes more critical. Advisers and their clients considering index funds need to ask themselves: Does the provider ramp up the real cost of a fund to make up the difference of the low-priced trading services they purport to offer?
With this in mind, there is a broad universe of actively managed funds that address some of the risks outlined above and that may charge lower fees. Ultimately, the key is to find one that combines active management with a reasonable price structure.
The following are four attributes I believe every actively managed fund should have:
Well-established players. Managers will come and go and funds will even change their name. Although past results are not indicative of future performance, I believe it's important to consider funds that have a proven track record of delivering results to investors for at least five years, preferably more.
Decision-making by committee. Some funds have a deep bench of qualified investment professionals who come together and make well-researched recommendations to an experienced fund manager. Not only can this type of arrangement potentially yield better results, it helps ensure that the fund's fortunes are not tied to a single individual. That said, some funds run by single individuals produce consistently solid returns year after year.
Falls within an ideal beta range. Beta measures a portfolio's volatility relative to its benchmark. Look for fund managers that consistently outperform the market without assuming a great deal of risk. Typically, such managers have a beta less than the S&P, which is 1. But everyone has different objectives, and investors willing to be a little more aggressive should not shy away from fund managers with betas greater than 1, if they think the potential performance justifies the additional risk.
Reasonable fee structure. For some investors, several years of great returns justify a hefty price tag. Remember, it may be OK to pay higher fees if you are getting the results you want. Sometimes, cheapskates get cheap results.
For advisers serving investors looking for low-cost options, index funds remain a very viable option. But with certain index funds, the fact is that you get what you pay for, which, in some cases, is not much. And while there's no question that some actively managed funds have outsized fee structures, I believe fees have become unfairly stigmatized in our industry.
In the end, some actively managed funds are everything their critics contend — unduly expensive, underperforming. But there remains a select group that have a proven ability to effectively balance performance, risk and fees, which makes them worthy of consideration.
Andrew Ahrens is chief executive of Ahrens Investment Partners, an independent wealth management firm.
