Legendary investor Warren Buffett, who has built his fortune actively choosing individual stocks, has said that most investors should go the passive route by parking their portfolios in low-cost mutual funds and exchange-traded funds that replicate the performance of market indexes. His rationale: Beating the market is difficult, even for investing pros like him, so amateurs are better off earning returns that match the market.
Plus, index funds and ETFs are cheap, with the average passive fund charging an expense ratio of 0.13%, compared with a 0.66% average fee among active funds, according to Morningstar.
Fans of active funds pay higher fees to invest in actively managed funds, though, in an attempt to beat the market with the help of a manager or a team of managers. That's a tricky proposition, but it's not impossible. In the 15-year time span that ended in 2019, 37% of mutual funds invested in U.S. stocks outstripped their benchmark index in a given year, on average, according to Morningstar.
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If you do decide to hold actively managed funds, make sure you're getting what you pay for.
Examining a few key metrics can give you an idea if an active fund in your portfolio is heavily mirroring a market index. If you're investing in a passive fund in active clothing, you could be overpaying, says Todd Rosenbluth, head of ETF and mutual fund research at investment research firm CFRA. "If you own a large-company fund which charges 1.00%, it's worth looking at," he says. "You can get exposure to the S&P 500 through an ETF for 0.03%."
"There are a number of different ways that investors can seek to understand just how much an actively managed fund might look like an index fund they can otherwise own and pay less for," says Ben Johnson, director of global ETF research at Morningstar.
One tool at many investors' disposal is "active share," a metric available on the websites of several mutual fund firms, including American Funds, BlackRock, T. Rowe Price, and Vanguard. Expressed as a percentage, active share indicates what portion of a mutual fund's holdings differ from its benchmark index. A 75% active share, for example, means that 75% of a fund's holdings are different than the holdings of the index. The closer a fund's active share is to 0%, the more it resembles its benchmark.
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Another such measure is tracking error. It's "one that gets thrown around in professional investing circles," says Johnson, and may also be available in your brokerage's mutual fund or ETF screener. This statistic measures how closely a fund tracks its benchmark index. Funds that perfectly match the movements of their underlying benchmark will show tracking errors of a fraction of a percent. The iShares Core S&P 500 ETF, for instance, has a tracking error of 0.01%. The higher end of the range for a passive fund would be 3% to 5%, says Johnson. The ARK Innovation ETF, an actively managed fund, carries a tracking error of 18.8%.
"If an active fund's tracking error is consistently low, the manager might be on a pretty tight leash," Johnson says. "The fund may not be all that active."
But these measures aren't the be-all and end-all, says Johnson. "In both cases, they have no predictive value with respect to a fund's long-term performance. You can have low tracking error, low active share, and produce really terrific performance by making a handful of really savvy bets."
If you're paying active-management fees for a passive-looking fund, it's worth looking into the fund's strategy to see if substituting an index fund might make sense.
Rosenbluth recommends starting with the portfolio, which will be partially available on the fund's website. "Look at your actively managed fund's top holdings," he says. "If it holds Apple, Microsoft, Amazon, Facebook, Tesla [the same top-five as the S&P 500], the fund may not be attempting to add the value you hoped it would through security selection."
Active funds with hundreds of holdings should raise investor eyebrows, too, he says. "If a large-cap equity mutual fund holds 300 or 400 stocks, it's likely a closet index fund largely representative of the S&P 500, or it's not a large-cap fund at all," he says. "They're either dipping down and holding small and midsize stocks (in which case we couldn't consider them a large-cap fund), or they're buying foreign stocks like Nestle and Alibaba."
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Any fund that has been a consistent underperformer also warrants scrutiny. Ignore 1-, 3-, 5-, and 10-year numbers, which could be skewed by recent returns, and focus instead on year-over-year performance. If a fund lags peers and its benchmark index year in and year out, it may be time to sell.
And if after analyzing a fund, you still find yourself on the fence as to its value in your portfolio, err on the side of lower-cost funds. "The only data point we've found that is in any way reliable in predicting future fund success is fees," says Johnson. "The less you pay, the more you get in terms of future returns."
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