Christine Benz: Hi, I'm Christine Benz for Morningstar.com. What should investors expect from active management? Joining me to discuss that topic is Russ Kinnel. He is director of manager research for Morningstar. Russ, thank you so much for being here.
Russ Kinnel: Good to be here.
Benz: Russ, you look at data on fund performance on a daily basis. When you monitor this question of active versus index, do any trends emerge in terms of where investors should choose index funds and where they should definitely go active?
Kinnel: I think only sort of. I think in small caps and some foreign-market areas, yes. It's true that historically active has done a little better there than, say, in large cap. But I think it's not nearly as dramatic in one direction or the other as people suspect.
Benz: So, when should investors automatically think indexing is a good idea?
Kinnel: I guess I would come at it from a couple of angles. The most important thing is low cost. A low-cost index fund is almost always a good idea. On the other hand, I think you can go at it from a completely different angle and say, "Where can I find some really good, low-cost active funds and use low-cost passive funds to fill in those different spots?"
I don't think it's that important where you go one way or the other. It's a little different, I guess, in intermediate bonds, where passive means a very Treasury, government-heavy portfolio, and active typically means more corporates, maybe some mortgages, maybe some overseas exposure. So, from a planning standpoint, that's also part of the equation as well.
Benz: You maybe get a little more diversification with that actively managed bond portfolio versus buying that Barclays Aggregate Bond Index tracker.
Kinnel: Right, you're really doing some sector- and overall-portfolio positioning when you choose active versus passive in bonds. So, you kind of have two levers going at the same time.
Benz: When we look at the trends in fund flows certainly over the past couple of years--but really five years now--we've seen this strong investor preference for index funds at the expense of active products. Does some of that trade seem a little overdone to you? Do you think perhaps investors are being too black and white about the index-versus-active debate?
Kinnel: Definitely. I think if you go back to '08, which is what everyone's touchstone is on this, both active and passive equity funds get crushed. It's not that active did much worse than passive, but I think there are good funds in both camps. I think you want to be careful either way; you want to get a low-cost fund. You could buy a higher-cost index fund, which doesn't make sense, either. There are a lot of good active funds that are in redemptions right now, and that doesn’t make a lot of sense to me. I think you want to find a good, well-run, low-cost fund and, to me, active versus passive is not the most important part of that equation.
Benz: So, the hitch with some active funds--and you wrote about this in a recent article--is that by the time investors buy many of these funds, after they've had very protracted runs of strong performance, investors can get themselves into trouble. Can you give us some examples of when this has happened in the past and also what sorts of lessons those situations illustrate for investors who maybe think they want to have room for active funds in their portfolios?
Kinnel: I think one of the reasons people don't like active funds is because they may have bought one of the really hot funds--one of the funds that just keeps crushing the index--only to be really disappointed. And I think part of that is just selection. If you are choosing something that's taking big risks [in order to beat the index], you may be setting yourself up for some disappointment. You think about a fund like Fidelity Magellan (FMAGX): [It took] tremendous risks and did beautifully for a long time. Everyone had to own it, and then the asset size and other problems just led it to a very poor performance.
Legg Mason Value (LMVTX) was fund under Bill Miller that had an amazing record of consecutive victories over the S&P 500, only to then fall victim to, I would say, asset size--but also just a matter of its sector biases having worked for a while and then they stopped working. So, I think there are some lessons there in terms of not necessarily going after the hottest, most popular fund. But it's also about having the right expectations and choosing the right active fund.
Benz: So, when you think about advice that you would give to investors who might be thinking about buying a given active fund and what sorts of expectations should they have for the fund, you said they should be prepared for a bumpy performance if it's been a very good performer. Anything else that they should expect from the fund? Also, what should they expect of themselves if their plan is to hang on and get a good result from owning this fund?
Kinnel: I think there are a few things you want to keep in mind. The first is that active managers, if it's stocks, are maybe looking out five, 10, or 15 years and, really, their goal is over the long term to add value. So, if we instead look at it on a one-year basis and read too much into a one-year performance, we're really looking at the wrong thing. And unfortunately, that one-year number really has noise more than signal, and so you really need to look out longer term. That means, if you buy an active fund, you have to tolerate a couple of down years. Even the best investors--the Warren Buffetts of the world--have had down years.
So, you've got to really understand, going in, that that's part of the equation. But you want to focus on the fundamentals as well, so that if there really is a change--the manager leaves or there's a strategy shift--then you do want to get out. But you don't want to react too much to short-term performance.
Benz: Russ, thank you so much for being here. This is such an important topic--I think one that's very much on investor's minds. We appreciate you sharing your insights.
Kinnel: You're welcome.
Benz: Thanks for watching. I'm Christine Benz for Morningstar.com.