Index Investing vs. Actively-Managed Mutual Funds

by: Roger Nusbaum

A question came in a few days ago from a reader who said he was not comfortable knowing which foreign countries to own, or how to access any countries he might think he wants to own. He reasonably asked: Why not just buy a couple of actively managed OEFs (mutual funds) and let experts do the work for you?

It should be obvious that any choice you make will have pros and cons. I would think weighing the pros and cons of whatever you choose would be a priority, so you know the drawbacks. This is not to say you shouldn't buy an active fund just because I don't, but to realize that no choice is perfect.

The reader mentioned owning, I believe, three actively managed foreign funds. There are several drawbacks. The first one is sector makeup. What if all three had overweighted the financials going into the dip during the summer? The funds would have been hit harder than an index fund or maybe a mix of common stocks (depending on the mix). Further, what if in addition to overweighting financials, all three had Northern Rock at an 8% weighting?

I concede the chances of the above are remote, though not impossible, but more general problems with overlap in accounts with a bunch of actively managed OEFs happen all the time.

If you use an indexed product you know how much exposure you have to a given sector at all times, and you know what the exposure will be, approximately, six months from now.

That brings up another issue - a fund manager is just like anyone else. He will get some right and get some others wrong. Chances are he is where he is because he is right more often then not, but a manager being wrong at exactly the worst time possible doesn't seem like a stretch to me.

From the top down, I want to control the sector weightings, country weightings, the yield, volatility, cap size and style very precisely, as I imagine most top down managers would want to. The more actively managed products you use the tougher that becomes.

You need to weigh out for yourself the right way to access all the market segments you want to own, drilling down as narrow as you are comfortable with. Obviously I go narrow, but that may not be right for you for a whole bunch of different reasons.

One last note on this - I would not describe the above mentioned use of indexed products as passive. In smaller accounts where I have fewer holdings and use sector ETFs, I actively manage, as best as I can without having 45 holdings, to work in all of things mentioned above. This is something anyone can do if they have/want to spend the time to allocate an account this way. I think of 'passive' as what the DFA guys do.