Passive investors feel bear's bite

Indexed or actively managed?

Selecting a fund type was easier during the stock market's long bull run, when investors tied to the big indexes just kept riding upward.

But with the Standard & Poor's 500 Index and Nasdaq Composite Index both in bear-market territory - down 20 percent or more from their peak a year ago - actively managed funds are more likely to be found in the plus column.

If most of your mutual-fund assets are tied up in index funds, you are down today. Reason: Indexes reflect the market.

Through March 12, for example, if you are in a fund linked to the S&P 500, you are down 10.4 percent for the year so far. For the past 12 months, you are down 14.4 percent.

Guess what? The average actively managed diversified equity fund, according to Chicago-based information-firm Morningstar Inc., lost less ground during those time periods - down 10.2 percent year to date, and down 13.7 percent over the past 12 months. Not only that, roughly 53 percent of the 4,514 actively managed funds tracked by Morningstar beat the S&P 500 this year through March 12. And roughly 49 percent of some 4,073 funds followed by Morningstar over the past 12 months beat the S&P 500.

So for the most part, actively managed funds are beating index funds.

What's the difference? "The value added by the fund manager," says one statistical analyst for Morningstar. "In an actively managed fund, the fund manager is taking as many steps as possible to stay ahead of the market, something the typical index-fund manager can't do because his fund tracks the market."

Moreover, she says, actively managed funds tend to have a significant cash component, unlike index funds, which are fully invested in stocks. That cash acts as a brake for managed funds.

Since index funds began to capture a larger percentage of investor dollars in the early 1990s, the mantra from consumer advocates has been virtually uniform: "You can't beat the market. So play it safe and stay with a no-load, low-cost index fund."

Advocates of no-load index funds include many of the brightest names in the industry, including John Bogle, who founded the index-oriented Vanguard Group. He believes that since the stock market is "efficient," low-cost index funds make the most sense over time. A person may momentarily do better with a managed fund, he says, but when you deduct initial sales charges and other investment costs, actual returns tend to fall back toward the mean - in other words, toward the index. Moreover, when the market rebounds, index funds historically tend to outperform actively managed funds over time, he says.

If you are not currently invested in stock funds, you "may not want to put new money in the market," Mr. Bogle says. But if you are already in index funds, "suck in your gut, take a deep breath, bite your tongue, and stay the course."

When the market does begin to rebound, Bogle says, "your indexed fund will be fully invested and taking advantage of market gains." Actively managed funds, by contrast, will have a cash component and not be fully invested and fully taking advantage of gains, he says.

But not all fund analysts are geared just to indexing. "The S&P 500 Index is not the passively managed index that many people assume it is," notes Tim Schlindwein, who heads up Schlindwein Associates, a mutual-fund consulting firm in Chicago. "The index has changed in recent years, becoming much more technology oriented than a decade or so ago," he notes. Thus, when technology stocks are climbing, that pushes the S&P 500 up. Likewise if tech stocks fall, the index follows suit.

By contrast, Mr. Schlindwein notes, managed funds geared to value and small-cap stocks are less likely to be linked to the S&P 500 and have lost less ground than the index.

The issue is not really "either or" says Schlindwein. Rather, he says, an investor should focus on his or her unique investment goals. One might thus have an index fund as a core holding, and actively managed funds that are geared toward a particular goal, such as growth or value, he says.

Sheldon Jacobs, editor of the No-Load Fund Investor, published in Ardsley, N.Y, is also wary of index funds geared to the S&P 500. "There's too much frequent change in the S&P 500. That's one reason why I prefer using a total-market index fund, instead of an S&P 500 fund, as my core index holding," he says.

Total-market funds are generally based on the Wilshire 5000 index, which includes more value and small company holdings than the S&P 500 index.

Mr. Jacobs for his part, tries to balance his holdings out at about 50 percent index funds, and 50 percent actively managed funds.

In addition, many fund groups with a large selection of funds usually have some that outperform the market. Both Fidelity and Vanguard, for example, currently have about 20 managed funds running ahead of the market. And people who own mutual-fund shares in tax-sheltered retirement plans can usually move from one fund to another for little or no charge. By making a quick phone call, these investors can switch from a losing fund to a winning fund. But analysts warn against such a strategy.

"Buying into the top-performing funds of the moment is one of those ideas that seem very good, but unfortunately, the laws of economics just won't allow," says Russ Kinnel, who heads up fund analysis for Morningstar. "To make this strategy work, you have to be able to time the market, and market timing, even for the experts, is very difficult," he says.

(c) Copyright 2001. The Christian Science Monitor

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