There is a perceived notion that technological advances have rendered actively managed mutual funds obsolete. However, nothing could be further from the truth. In point of fact, approximately 70% of U.S. assets are invested in actively managed funds.
Old Concerns with Actively Managed Funds
Because active funds have been around longer, there are a lot of misconceptions about how actively managed funds actually function today. In past decades, investors often had to pay high load fees just to get into mutual funds. These loads could run as high as six percent, and the brokers that sold the funds would get part of the load as a commission. This created a clear conflict of interest. The broker had an incentive to repeatedly get the client into and out of funds in order to earn commissions.
This conflict of interest that plagues the broker-client relationship led to the rise of independent wealth management firms like ACG. At ACG, our compensation is not tied to which investments we buy, sell or recommend to our clients. Our interests are always aligned with your interests.
New Issues with Passive ETFs
Many of today's mutual funds are available in a no-load arrangement, but many ETFs actually have a problem that is quite similar. In many scenarios, when you buy or sell an ETF, the custodian may charge a commission to process the transaction. These commissions are much lower than six percent commissions but they could range from $4.95 per trade up to $19.95 per trade or higher. On large trades, this is not a big deal, but on smaller sums, it could eat into returns. (Some custodians do offer select ETFs in a no-commission offering.)
Another potential issue with trading ETFs is the bid/ask spread. The spread could be based on the trading volume on the underlying positions inside the ETF. The most liquid ETFs like the SPDR S&P 500 ETF – ticker: SPY - can easily be bought and sold for the intrinsic price. As you move into ETFs that hold less liquid securities there is a risk that the spread to buy and sell may increase resulting in less favorable pricing.
Here’s another situation that can result in higher spreads. If an investor purchases an international ETF during US trading hours but the international market is closed. To avoid taking on too much risk, the market maker requires better pricing resulting in a bigger spread – this results in a higher cost to the investor. Yet, another example when bid/ask spreads widen may be during times of high volatility. When market volatility increases, the spread on less liquid ETFs increases to protect the market maker from suffering significant losses. Many retail investors and some advisors don’t consider these factors when trading ETFs. The more things change, the more they stay the same.
We often hear how 70% or more of actively managed mutual funds underperform the S&P 500, but for some reason, we never hear about the performance of passively managed ETFs. We always hear how cheap they are but investors don’t seem to hold them to the same return standard. A majority of ETFs do a good job of replicating the underlying benchmarks, but how does that performance compare to other investment alternatives or doesn’t it matter because they are cheap?
There are certainly good ETFs, just as there are good actively managed funds. The market has recently been introduced to a new type of passive investing available in an ETF product that follows specific rules to determine the portfolio construction as opposed to company size as traditional indexes follow. These “rules-based” strategies have been given the nickname of smart beta. Smart beta ETFs attempt to replicate many of the strategies of successful active fund managers, but they also charge higher fees than market capitalization-weighted index ETFs. On the other hand, the fees charged by active managers today have declined resulting in a smaller cost benefit between actively managed mutual funds and smart beta ETFs.
A Time-Tested Way to Pursue Your Investment Goals
Passive funds are undoubtedly the best way to track the S&P 500, but actively managed funds are more attractive when building a customized asset allocation. Tracking the S&P 500 becomes less important as you grow older, and active funds can play a key role in your asset allocation for retirement.
If an active manager is selected using a disciplined process and given the time of a full market cycle, we believe using active strategies can provide better investment results. Finding the best active funds for your investment goals is never easy, but we bring a wealth of knowledge and experience to the task.
Actively managed funds still have an important place in a properly diversified portfolio. The ETF industry right now is a lot like a child so eager to play with all his shiny new toys that he's bound to end up breaking something. As adults, we've learned to be cautious when trying new things. Actively managed funds bring that same sort of mature approach to pursuing your investment goals.
The ACG Difference
We aren’t paid any more or less if we advise investors to take a passive or active approach to their investments. There are circumstances where we might use active or passive strategies, but we always do what we believe is right for our clients. When you decide to work with ACG, you can be confident that our investment selection and portfolio construction process is disciplined and consistent.