Yes, I actually do believe that Active Mutual funds are a good thing. Investors pick active mutual funds for many reasons, and I know because I used to do the same.
Why Investors Pick Active Mutual funds (vs Index funds)
1. Fund Ratings
I had heard of Fidelity through a colleague and had opened an account there, but now needed to figure out which investments to make. After a few hours of googling, I had narrowed down my list of websites to research the funds I wanted.
- The Fidelity Fund Screener
- Morningstar, the big daddy in this space
- Lipper Leaders
- Max Funds – they provide a numeric “score” to each fund, thus making it easy to compare
For a nerd like me, the ability to filter and sort and compare scores and ratings under a microscope was like a dream come true. I could slice and dice across asset classes to my heart’s content. The amount of information provided by these tools was mind-boggling. After all, here I was an average guy looking for where to invest and all these professionals had put all this awesome information out there – for free. Oh, and it was all data-driven and you can’t dispute that, can you? 🙂
2. Fund Performance
Despite the “past performance is not indicative of future results” that’s always thrown in your face, everyone looks at performance. Every single one of us. I do it too.
Why? Because we’re always curious, wanting to make sure we’re on the right track. Ultimately, we all want to ensure our investments are doing what they should get us to our desired (minimum) net worth. There’s nothing wrong with looking at performance, especially with every brokerage and personal finance software offering that information up readily. It’s many a night I’ve spent poring over 1, 3, 5, 10-year returns for funds – active or otherwise.
A new-ish investor starting out is bombarded with performance ratings. I invariably subscribed to Kiplinger’s and CNN Money and the “Top 20 funds to buy” list were a special attraction. To be clear, I think these magazines are great and go a long way in educating the consumer on personal finance topics. However, they are in the business of selling magazines. You need to remember to pick and sift through the advice that is relevant and useful to you.
Key takeaway: Always compare performance after fees and taxes and don’t take any numbers at their face value.
3. Fund Fees are Opaque, or worse, Ignored
It’s easy enough for an active fund to outperform an index fund over the short-term. Investors could decide that a percentage point or two in mutual fund expenses doesn’t mean that much. And once again, they could hitch their financial wagon to a superstar manager with a hot track record for the past few quarters or years.
The majority of an individual investor’s investments are in retirement plans provided by their employer. This means that a lot of their investments are in funds that may not be cheap, with various load and marketing fees tacked on.
So where does this leave us?
There Are No Shortcuts
I bought and sold many a fund over the first few years, filtering out the low-performing ones on a regular basis. I kept the ones that did reasonably well-comparing returns one year at a time. It is only when I came across the Vanguard Diehards (now Bogleheads) that I was exposed to the idea of Index funds. My eyes opened to the expense ratios and comparative fees and the realization that Morningstar ratings didn’t predict fund performance as reliably as I wanted them to.
The more I read, the more I started to switch my investments over to Index funds. It wasn’t until a full ten years after I started investing that I drank the Kool-Aid and finally switched to 100% index funds.
And I wouldn’t change a thing.
Trial and Error
I think we all know that the earlier in life a person begins to manage their investments, the better off that person will be. What’s also important is the path you take to learn how to manage your money.
Investing is not part of required coursework at any high school, trade school or college. Hence, one learns through trial and error. This is sometimes an expensive lesson, but most investors don’t start out rich. They start out young, with a few thousand dollars to their name. This is the best time to invest in active mutual funds, as they have less $$ to lose. When they do so, here’s what will happen:
- They will realize that real out-performance by active funds is fleeting, and not sustainable.
- Index funds need to stay invested at all times, as they need to replicate their underlying index. This means unless they’ve panicked and sold them in a downturn, they will always stay invested and ride the market back up.
- They will save a ton on taxes and fees, compounded over time.
- They will learn to recognize and filter out all the good information from the noise.
Some lessons are best learnt by experience, and this is one of them.
What do you think of active vs index mutual funds? Do you have one or both in your portfolio? Why or why not?