The downside of passively investing, such as in index funds, may have cost you dearly over the past year. While you did well, with gains in your retirement portfolio helping ease your concern, had you been in actively managed mutual funds, you would have done better.
Juliet Ellis, chief investment officer for U.S. growth investing in the AIM unit of Invesco Ltd. and a lead portfolio manager of three small-cap funds recently suggested that index funds have got it backwards in terms of strategy. Consider for a moment how index funds are built. When a stock performs poorly, warranting removal of the stock from the index, this mimics the most common mistake of the average investor. They sell their share when the stock price is low.
On the other side of the coin, the index adds a stock that has been performing well, in essence, buying at the top. says one drawback of index investing is that stocks typically are added to an index when they’re up and removed when they’re down. In the year following the collapse, some previously well performing companies saw their share value devastated and this event triggered a readjustment in the major indexes.
Was that the right thing to do?
The argument for indexing, a method of passively allowing your investment to follow these indexes in the hope of supply diversity and lower fees, may have cost you in the previous year according to recently released numbers for 2009. If you made the move at the bottom to these types of funds or their newly hyped counterpart that rests itself as time passes, the Target Date fund, you were not alone.
According ot a recent article in the Wall Street Journal, “In the 11 months through November, managed stock funds and ETFs experienced estimated net inflows of $5.88 billion, while stock index funds and ETFs took in about $11.22 billion, according to data from FRC. In 2008, investors placed an estimated net $184.28 billion in stock index funds and ETFs, while some $238.33 billion was yanked from managed funds and ETFs.” The ETFs or exchange traded funds are priced throughout the day (as opposed to index mutual funds which are priced at the four pm market close) are also index funds.
In any given year, a handful of active mutual funds will do better than the benchmark index fund. And investors are usually warned, and I obligated to as well, that what is hot today or last quarter, even over the past year in all likelihood will not be so after you invest. This is why it is always recommended to look much further afield, at least five years, ten is even better see how well a fund has performed.
One of the other arguments against active mutual fund investing is one of purity. Active managers often drift, what is referred to as style drift, from what they may have been hired to do. This drift might be a switch from large-caps to a smattering of mid cap offerings. For the vast majority of active fund investors, of which I am one, this really doesn’t matter all that much.
The bottom line is to survive the troughs doing better than the benchmark, outperform the benchmarks when the indexes are up, and do so without a huge amount of turnover (how often the portfolio changes in a given period – more than 100% would be considered worrisome while 50% is a good target) and make enough to cover any other fees for the fund’s management.
Those arguing for index funds will always seek to shape the argument around fees. High cost (over 1.5% is considered an insurmountable number to indexers) will always be at risk of criticism when numbers, such as those posted by actively managed funds in 2009, are reported. Low fees do trump in many cases but they do so by eliminating risk and in many instances, trailing where they could have been. Most index funds charge less than 1% for their services with some almost charging nothing.
The temptation to repeat the mistakes you may have made in your 401(k), selling at the bottom and shifting to a much less risky investment such as index funds, ETFs or target date funds is understandable. Selling as the market recovers, and your portfolio albeit at a slower pace than had you stayed put, would be just as counterintuitive.
At this point, you might want to approach the opportunity by channeling new money (increasing your payroll deduction by a percentage or two) into actively managed funds. While you will increase your risk, if 2010 is anything close to what the most popular punditry suggests, we have quite a lot of upside. And if in 2010 we see some credit easing (less requirements rather than just low interest rates) and jobs begin to return in a meaningful way, they could be right.
Keep in mind, all markets tend to be cyclical. Diversity tries to capitalize on these shifts. And while actively managed funds may be doing well and may do so in the next year, some more conservative exposure will also be needed. The gains may not be as great, but the downturn, and this is what is meant by cycles, will hurt less as well.
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