This article is part of the Morningstar's Guide to Active vs Passive Investing. Click here for our edit on how the experts use the tools at their fingertips, finding out whether you prefer one to the other and examining how to blend active and passive investing for profit.
Christine Benz: Hi, I'm Christine Benz for Morningstar. 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, a 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 2008, 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, 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.
This video originally featured on Morningstar.com and has been edited for a UK audience
