What are actively managed funds?

Actively managed funds rely on trading decisions to enhance returns

An actively managed mutual fund, or exchange traded fund (ETF), is a fund that relies on the decisions of an investment manager or team of managers to select the fund’s holdings. The goal is to surpass passively managed mutual funds, which match and follow an index of holdings such as the Standard & Poor’s (S&P) 500 or the Nasdaq Composite Index.

Actively managed fund managers typically adhere to an investment strategy that is defined in the fund prospectus, but have the flexibility to buy and sell investments based on their research.

Although actively managed funds account for the majority of long-term fund assets - about 60 per cent at the end of 2020 - index funds have more than doubled their share of long-term fund assets since 2010.1 Passively managed funds have grown in popularity as more investors have learned that these funds vastly outperform actively managed funds and carry lower management fees and portfolio turnover costs than actively managed funds.

Definition and example of actively managed funds

Actively managed fund managers seek to take advantage of market inefficiencies through analytical research, forecasting and their own judgement to outperform funds that simply follow a market index.

The concept of investors pooling their money to have someone else invest on their behalf was introduced in the US in 1893 by the Boston Personal Property Trust. Investments in that early fund were more based on real estate than on stocks or bonds. The first actively managed fund that most closely resembles today’s stock and bond mutual funds was the Alexander Fund, introduced in 1907.3

The popularity of mutual funds went back and forth during the Great Depression and for several more decades. As the country recovered from the stock market crash of 1929, the US Congress created the Securities and Exchange Commission (SEC) in 1934 to protect investors from fraud and unfair sales practices, a role the SEC still plays today.4 The mutual fund industry grew over the decades, and index mutual funds were introduced in the 1970s.1 But actively managed funds dominated the scene during the bull market of the 1980s and 1990s. Peter Lynch of Fidelity, who managed the firm’s Magellan Fund from 1977 to 1990, averaged an annual return of over 29% during that period.

How actively managed funds work

Investors who wish to attempt to outperform market indices may choose to select their own stocks or invest in actively managed mutual funds. Some investors invest in both index funds and actively managed funds.

Managers of actively managed mutual funds are usually supported by a team of investment analysts. The performance of an actively managed fund is usually measured against a benchmark index that more closely reflects the fund’s investment strategy. Performance over various periods, such as one, three and five years, can be found in the fund’s prospectus. The prospectus will also list the management fees and provide information on the fund managers, including how long they have managed the fund.

For example, the prospectus for the Fidelity Magellan Fund (FMAGX), which was a big flyer when it was managed by Lynch, shows that at the end of October 2021, it had returned just under 38 per cent over the past 12 months and had an average annual return of about 21 per cent over five years. In contrast, its benchmark, the S&P 500, had returned nearly 43% over the same one-year period and had an average annual return of just under 19% over the past five years.6

Most actively managed mutual funds fail to beat their benchmarks. The S&P Indices vs. Active (SPIVA) research scorecards published by S&P Dow Jones Indices compare the performance of actively managed equity and fixed income mutual funds with their benchmarks. The company reported that about 73% of actively managed large-cap US equity funds have underperformed the S&P 500 over the past five years. Over the same five-year period, nearly 67% of actively managed small-cap equity funds underperformed their benchmark, the S&P SmallCap 600.

Pros and cons of actively managed funds

The debate on whether actively managed funds are better than passive funds will probably continue forever among investors. However, there are positive and negative facts about actively managed funds that cannot be disputed.

Pros

• They provide access to professional stock pickers: Many fund managers have years or even decades of experience and usually deep teams of analysts who help them pick stocks.
• They can outperform benchmark indices: Fund managers aim to outperform their passively managed benchmark index funds by conducting extensive research and trying to take advantage of market inefficiencies.
• Management fees have fallen: Morningstar reported that the average actively managed fund expense ratio for investors has fallen by more than half since 2000. From 2016 to 2020, the average expense ratio for active funds fell 11%, while the average fee for passive funds fell 12%.

Cons

• Most underperform their benchmark index fund: It is a fact that the majority of actively managed funds underperform their benchmark index. It is common for more than 70% of actively managed US large-cap funds to underperform their benchmark.
• Past performance is no indicator of future results: Every prospectus will tell you the same. Even when a management team works together for years, the performance of actively managed funds can vary widely from year to year when measured against their benchmarks.
• Higher commissions and other costs: Although index funds with generally lower commissions have put pressure on broker fund families to lower the cost of their actively managed funds, the latter routinely have higher costs than index funds.

Key points

• Actively managed mutual funds, or ETFs, rely on the research and decisions of an investment manager or team of managers to select fund holdings.
• The performance of an actively managed fund is usually measured against a benchmark index that reflects the fund’s investment strategy. Most actively managed funds underperform their benchmark indices over time.
• Due to their management style, actively managed funds usually have higher costs than passively managed index funds.

Source of this article: www.thebalance.com