In my last post, I wrote about Index Mutual Funds as an investment strategy.  To index or not to index?  This has been a long debated question among investors for years.   Specifically, is it easier to simply buy and hold a basket or stocks or bonds?  Or should you take your chances and buy actively managed mutual funds that try to outperform the averages or indices.

Conventional Wisdom

The conventional wisdom is that actively managed funds do better in flat or down markets while the indexing does better in bull markets.  There is some evidence to support this claim.  For example, the S&P 500 index beat Morningstar’s large blend category every year during the bull market in stocks form 1995-1999, then lagged in 2000 and 2002 until outpacing the category in 2003′s bull market.   In general, the average large blend fund trailed the S&P 500 consistently during the bull market but beat it some of the time during bear markets.

There are a few possible reasons to explain this.  Index funds are typically fully invested while active managers periodically hold cash and as a result are partially out of the market during strong advances.  Also, active managers try to time the market in order to improve their returns.  Conversely, during down markets, active managers may allocate a higher percentage of their portfolio in depressed growth stocks.

Size Does Matter

Another piece of conventional wisdom is that actively managed portfolios can outperform the indices in less liquid or inefficient asset classes like mid-cap, small cap or foreign stocks.  There is some research to support this.

Keep in mind if you choose to invest in actively managed mutual funds, you need to “stay on top” of your fund’s returns.  This would require you to “benchmark” the actively managed funds versus their relative benchmark at least quarterly.  In doing so, you would also need to develop an “investment policy” or plan that includes your strategy or discipline for selling an underperforming fund and buying an alternative whenever certain criteria was breached.  For example, you may choose to replace a fund that underperformed it’s given benchmark 4 consecutive quarters.

Which Strategy Is Right For You

To review, proponents of actively managed mutual funds believe that certain fund managers have the ability to outperform their peers over time by handpicking and selecting particular companies and avoiding others.  Proponents of indexing or the passive approach  believe all the available information is already priced into the market.   Further, they believe actively managed funds will under perform over time due to higher fees.

A better solution could be to combine both strategies.  Specifically, by using index funds for more well known asset classes like investment grade bonds and large cap stocks, while using actively managed portfolios for less efficient asset classes like small cap stocks and foreign stocks can give you the benefits of both styles.

Related posts:

1. Index Mutual Funds as an Investment Strategy
2. 2 Free Tools To Track Your Mutual Funds Performance
3. Fixed Income Funds