The Case for Actively Managed Funds

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1 Page 1 of 7 This copy is for your personal, non-commercial use only. To order presentation-ready copies for distribution to your colleagues, clients or customers visit JOURNAL REPORTS The Case for Actively Managed Funds There Are Still Some Scenarios Where the Hands-On Way Might Make More Sense By MICHAEL A. POLLOCK February 8, 2015 Index funds clearly have won the hearts and minds of many investors. So are there any reasons to even consider actively managed funds these days? The naysayers argument in recent years has been a powerful one: The odds are against active managers beating the market. Most haven t beaten the market since So why pay the extra fees? Little surprise, then, that last year, people yanked $98.58 billion out of actively managed U.S.-stock mutual funds while putting $71.34 billion more into passive ones that merely track an index. Total assets of exchange-traded funds, which are built to mimic indexes, climbed past $2 trillion. But many advisers still believe that at certain times, and for certain strategies, actively managed funds are superior to index funds. That is particularly true, they say, if the active fund has a good long-term track record and charges lower management fees than most of its peers. Moreover, relative performance runs in cycles. If bull markets start to lose steam and targeting good stocks grows more difficult, historical data show that active funds as a group in certain categories could be poised to do better than comparable index funds some significantly so. Here s a closer look at those scenarios where experts say the case is strongest for active management:

Page 2 of 7 1. ILLUSTRATION: ANNA PARINI JOURNAL REPORT Insights from The Experts (http://blogs.wsj.com/experts/category/wealth-management/) Read more at WSJ.com/WealthReport (http://online.wsj.com/public/page/journal-report-wealth.

2 Page 2 of 7 1. ILLUSTRATION: ANNA PARINI JOURNAL REPORT Insights from The Experts ( Read more at WSJ.com/WealthReport ( mg=inert-wsj) MORE IN INVESTING IN FUNDS & ETFS () Tax-Smart Way to Draw 529 Funds ( Stock Funds Fell 2.6% in January ( Hedge Funds Win Cash Despite Losing ( The ETF Time Bomb That Isn t? ( When Fund Managers Are Neighbors ( When You Own Stocks for Income As yields have fallen, investors have flocked to dividend-paying stocks for income, and that has spurred rapid growth in dividend-focused ETFs. But to enhance their appeal, companies that sponsor such ETFs often design them with an easy-to-grasp mission such as generating the highest yields or owning shares only of companies that consistently boost dividends.

3 Page 3 of 7 Such ETFs often focus narrowly on certain sectors, such as economically sensitive or defensive stocks, says Todd Rosenbluth, director of ETF and mutual-fund research at S&P Capital IQ. They only sell a stock if it no longer fits the mission. Meantime, if market sentiment shifts away from the sector where an ETF is focused, that can hurt its overall performance. An active manager could limit the impact of such shifts by diversifying, Mr. Rosenbluth says Moreover, paying the lower expenses for a dividend-focused ETF doesn t always lead to better returns. Since 2007, actively managed Vanguard Dividend Growth (VDIGX) has beaten the returns of Vanguard Dividend Appreciation ETF (VIG) by more than one percentage point annually, says Alex Bryan, a passive strategies analyst at Morningstar Inc. While the ETF charges only 0.10% in expenses, the active fund charges 0.31%, which is still significantly lower than most actively managed funds in Morningstar s large-blend category, Mr. Bryan says. By paying 0.21 more, an investor gets an active fund that takes qualitative considerations into account and may react to changing fundamentals in a more flexible way than the rules-based ETF can. The debate isn t just about the benefits of active or passive, but about when it makes sense to pay a higher fee for a fund, says Mr. Bryan. 2. If Markets Start Trading Sideways Less than a fifth of large-cap U.S.-stock managers have beaten their benchmarks over the past five years. Performance actually was a little worse from 1995 to 1999, with only 18% topping the S&P 500 index. Returns for actively managed funds lagged behind those of the S&P 500 by an average of more than four percentage points a year in that stretch, says Aaron Reynolds, head of asset-manager research in the wealth-management unit of Robert W. Baird. However, the situation changed from 2000 to 2008, when nearly two-thirds of active large-cap funds beat the S&P, by an average of 1.4 points annually. The lesson here? Historically, active managers have lagged behind benchmarks during long, strong bull markets, when securities selection makes less of a difference. They tend to make up lost ground when markets level off or suffer corrections.

4 Page 4 of 7 Could that signal better performance this year? The bull market may still have life left. But if stocks struggle and companies find earnings growth harder to come by, that is a climate that would favor active management, Mr. Reynolds says. 3. When You Own Bonds Bond yields move in the opposite direction of bond prices, so if rates are headed higher this year, it could be risky to own an ETF that closely tracks a broad bond index. Some types of bonds would be particularly hurt, including Treasurys and certain mortgage-backed securities. One widely held bond ETF, ishares U.S. Core Aggregate Bond (AGG), has more than half of its portfolio in such rate-sensitive securities. That is because the index that the ETF follows reflects the composition of the overall bond market, where Treasurys and mortgage securities represent the largest types of bonds outstanding.

Page 5 of 7 Moreover, such ETFs can t change their portfolios to reflect concerns about rising rates, because they are obligated to replicate the performance of an index as closely as possible by

5 Page 5 of 7 Moreover, such ETFs can t change their portfolios to reflect concerns about rising rates, because they are obligated to replicate the performance of an index as closely as possible by owning securities in the index. As a result, at times when rates might be headed higher, such as now, investors may be better off in an active fund with the flexibility to reduce interest-rate sensitivity, says Karissa McDonough, fixed-income strategist in the wealth-management group at People s United Bank in Burlington, Vt. A manager can do that by holding fewer rate-sensitive bonds and buying more bonds that provide a cushion against rising rates, such as corporate securities. Flexible funds also can reduce overall rate sensitivity through a range of derivatives transactions. And they can build cash positions and move to the sidelines when certain market sectors grow expensive, she adds. This is a time when active management can really show its value, Ms. McDonough says. 4. ILLUSTRATION: ANNA PARINI When Investing Abroad ETFs make it easy to get non-u.s. exposure. But those based on market-cap-weighted indexes tilt toward the largest foreign markets, sometimes exposing investors to weaker economies, including, for now, Russia and Western Europe. Actively managed international funds can fare better at diversifying away from indexes, says Jon Hale, director of manager research, North America, at Morningstar. For example, he says, they can boost returns by buying stocks in faster-growing emergingmarkets nations that aren t included in certain widely used foreign-stock benchmarks, such as the MSCI EAFE Index.

6 Page 6 of 7 Over the past 10 years, U.S.-stock funds in the top 25% of their Morningstar rankings have beaten the S&P 500 on average by about one percentage point a year. But large-cap international-stock funds in the top 25% of their rankings have topped the S&P 500 on average by around 1.5 to 2 percentage points a year, Morningstar data show. Still, investors could lose the benefits of an active foreign fund if they aren t mindful of costs, says Tim Courtney, chief investment officer at Exencial Wealth Advisors in Oklahoma City. When possible, he says, investors should opt for funds that charge significantly less than the category average for annual expenses and that keep turnover or the amount of trading they do to around 33% or less of an overall portfolio a year. Fact sheets on fund websites and Morningstar show such figures. 5. If You re Worried About Volatility Limiting losses can help in building a nest egg. And some ETFs aim to provide downside cushion by focusing on lower-volatility stocks. These may include shares of large, bluechip companies and those that pay steady dividends, whose shares typically move much less than the S&P 500. But active managers have more ways to play defense, says Tim Clift, chief investment strategist for Chicago-based Envestnet Inc., a firm that guides advisers on using active and passive funds. They can own higher-quality stocks and trim positions as valuations rise. They don t have the pedal to the metal when the markets are going up, and they put the brake on more quickly when markets are going down, says Mr. Clift. Performance numbers can help identify such funds such as upside and downside capture ratios, which show how a fund s returns compare with the broad market in rallies and selloffs. One defensive fund with high Morningstar ratings is American Century Equity Income (TWEIX), which damps volatility by owning some equity-bond hybrid securities, such as convertibles. For five years, its returns captured about 74% of the rise in the S&P 500 index, compared with 96% for Morningstar s large value category. But on the way down, returns fell just 68% as much as the index, compared with 107% for the category. Mr. Pollock is a writer in Ridgewood, N.J. He can be reached at reports@wsj.com. Corrections & Amplifications

7 Page 7 of 7 The table showing managers relative performance against the S&P 500, in percentage points, was mislabeled as percent in an earlier version of this article. (Feb. 12, 2015) Copyright 2014 Dow Jones & Company, Inc. All Rights Reserved This copy is for your personal, non-commercial use only. Distribution and use of this material are governed by our Subscriber Agreement and by copyright law. For non-personal use or to order multiple copies, please contact Dow Jones Reprints at or visit

Modest Style Bets, Modest Price

Reprinted by permission of Morningstar, Oct. 21, 2016 Modest Style Bets, Modest Price ETF SPECIALIST 10-21-16 by Alex Bryan, CFA Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC) offers exposure