By Scott Reed
Almost everyone invests these days. That is true, in no small part to the emergence and proliferation of the mutual fund industry. Mutual funds have allowed small and large investors alike the opportunity to safely diversify their assets.
The fund business can be separated into two types of investment styles: active and passive. Active funds have fund managers that use their expertise to decide what types of securities should be bought and sold in their fund. They are the ones you hear so often in the media pontificating about what stocks or bonds are hot right now. They talk a great game, and they attract interest from the investing public by promoting their style of management.
There are sound reasons why one may want to invest with an active manager: They are looking after your interests on a daily basis. If something goes wrong, they are there to minimize the loss. They scour the earth to find the best of the best in their realm of expertise, which should naturally produce superior results for their clients.
With all of that being said, using an active manager makes sense. Especially when you look at what passive management has to offer.
Passive funds simply buy everything within their universe and hold it until it no longer is in their universe. For instance, an S&P 500 Index Fund will buy all the stocks in the S&P 500 and hold them, unless one is kicked out of the S&P 500. Then they sell it and buy its replacement. There is no analysis, no subjective brilliance applied to the strategy. It is what it is.
There is little argument that active management can produce superior returns in areas where markets are inefficient and trading volume is low. That is why active managers have always been able to charge more money to manage your assets than passive managers.
The problem is that, over the years, most markets have become extremely efficient. The fault is somewhat their own in that more and more investors are using mutual funds, which pushes more and more money into the markets.
That money has created much more efficient markets and made it much more difficult for most active managers to show any real value for the money they charge. A recent study showed that in the past five years, 66 percent of active equity managers and 80 percent of active fixed-income managers underperformed their benchmark.
If that is the case, why don’t more investors use passive management and accept the lower management fee they provide? The short answer is that most passive funds don’t pay anything to the person who recommends them. If you are using someone who depends on a commission for their income, a product that doesn’t pay anything is not particularly attractive.
Passive investment options are worth looking into, but don’t wait for someone to sell them to you. You may have to make that happen all on your own.
Scott Reed is CEO of investment advisory firm Hardy Reed in Tupelo. Contact him at (662) 823-4722 or firstname.lastname@example.org.