The Argument For Actively Managed Funds

by Jason Unger

Investors at computers trading

Look, it’s not going to surprise anyone that I heavily advocate investing in low-cost, passively managed index funds. They offer the best return on your money for most investors, and not only do they help you better understand your investments, they ensure that some salesperson isn’t hoodwinking you with their investment suggestions.

But I can understand why some people feel that actively managed funds serve a purpose and invest in them. And since I believe in individual freedom, I don’t have a problem if you know the downsides of active management but decide the risk is worth it.

There are two scenarios possible for the active investor:

  1. You pay someone to actively manage your investments
  2. You actively manage your investments yourself

Let’s look at the arguments for each case separately.

Why Pay Someone to Actively Manage Your Investments?

You know the stats: over a 20-year period, an actively managed fund has about a 3% chance of beating the S&P 500 index (research here) after expenses and fees. So if you’re a long-term, buy-and-hold investor, you’re almost always better off with an index fund.

But what if your situation is different? Maybe you’re not investing for retirement, or you get stock in a particular sector from work or …

Wikipedia offers up five cases where investors may prefer active management:

  • They may be skeptical of the efficient-market hypothesis, or believe that some market segments are less efficient in creating profits than others.
  • They may want to manage volatility by investing in less-risky, high-quality companies rather than in the market as a whole, even at the cost of slightly lower returns.
  • Conversely, some investors may want to take on additional risk in exchange for the opportunity of obtaining higher-than-market returns.
  • Investments that are not highly correlated to the market are useful as a portfolio diversifier and may reduce overall portfolio volatility.
  • Some investors may wish to follow a strategy that avoids or underweights certain industries compared to the market as a whole, and may find an actively-managed fund more in line with their particular investment goals. (For instance, an employee of a high-technology growth company who receives company stock or stock options as a benefit might prefer not to have additional funds invested in the same industry.)

Fair enough. While there are certainly index funds that would suit some of these goals (not every index fund tracks the entire market, or the S&P 500 — there are some that even track only “eco-friendly” companies, for instance), there are probably more options with actively managed funds.

The one argument not listed here is the “ability” of the fund manager. While we know that most experts can’t beat monkeys at picking stocks, every once-in-a-while a Warren Buffett comes along. But that’s a rare case.

And nearly all of the time, you’re not even close to Warren Buffett.

Why Actively Manage Your Investments Yourself?

Can you beat the market managing your own investments? Of course you can. There’s no argument that it’s possible, even among staunch advocates of index fund investing.

There are a few advantages to actively managing your own investments:

  • You can make the decisions that are specific to you, and not follow along with what some fund manager recommends
  • You don’t have to pay anyone to manage your investments
  • You have the ultimate freedom to build whatever portfolio you think makes sense

This is a high-risk, high-reward operation, and the ultimate do-it-yourself investing.

But because it involves trying to time the market, you’re edging closer and closer to trading, not investing. And since you likely don’t have the same information that most of the big investment firms on Wall Street have, you’re even further in the hole.

What advantages do you see in active management? Let me know in a comment below.

{ 1 comment… read it below or add one }

Lee Distad August 24, 2009 at 11:28 am

Excellent points, Jason. Of course, despite being in favor of self-managed investing, I would still quibble about the phrase “high-risk, high-reward operation.” I’m pretty outspoken about how risk and return are not directly correlated. Self-managed active investing can easily be a high-risk, ZERO reward operation.

I say that not to be negative, but simply to be realistic. Very few people, possibly nobody anywhere, can adequately assess risk until after the fact.

To answer the question you posed, I actively trade and invest because I believe in taking responsibility for myself. I own up to not only my good calls, but also my bad ones.

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