Q. I want to revamp my portfolio and use some actively-managed funds. Right now it’s all index funds. How can I tell if a fund’s expenses are too high or if they’re worth it?
— Making changes
A. Expenses are always a key part of the discussion when comparing index funds with actively-managed funds, but that’s only part of the conversation.
You also have to look at tax efficiency and performance.
Let’s start with tax efficiency.
Chip Wieczorek, a certified financial planner and investment adviser with Tradition Capital Management in Summit, said he recommends holding actively-managed mutual funds in tax-deferred vehicles such as IRAs, Roth IRAs or 401(k)s.
These kinds of accounts will offset the tax liability of any capital gain or dividend distributions from the fund, he said.
For investors who don’t have tax-deferred accounts, Wieczorek recommends using a separate account manager (SMA).
He said an SMA manager will buy a basket of individual stocks which gives the investor much more investment and tax planning control.
“For instance, if a mutual fund is holding a stock that has lost value, it does little for the investor if unable to realize the loss for tax purposes,” he said. “Unlike a mutual fund, the investor can have the SMA manager harvest the loss while purchasing a similar holding in that sector to keep participation in the market or hold cash and repurchase the same position after 30 days.”
In addition, he said, highly appreciated stock can be gifted to charity and the investor will get a tax deduction for the entire holding amount as well as avoid paying taxes on the gain.
When looking at the performance of an actively-managed fund you will probably come across the term “alpha.”
“Alpha is the excess risk-adjusted return a fund manager can provide relative to their index,” Wieczorek said.
He said you’ve probably heard that 80 percent of active managers do not outperform their relative index. This is true, Wieczorek said, but when you look deeper there are several variables to consider.
“For instance, when looking at low-cost fund managers, Morningstar reports that in 2015 just over 66 percent of large value mangers outperformed their index versus just under 19 percent of growth managers,” he said. “Most data suggests that your best results for using an active manager is in the small and mid-cap value space as well as intermediate term bonds.”
As you said in your question, cost is another variable to consider, especially given that statistics have shown that low-cost managers outperform their higher cost counterparts.
“In addition fund fees vary by asset classes, international and emerging market active managers will have higher fund expenses than a domestic manager,” Wieczorek said. “This is because of the additional costs required to have `boots on the ground’ and perform due diligence in foreign economies.”
He recommends you look for a fund with expenses in the lowest quartile relative to its peers and evaluate the long-term track record from there.
“Picking an active fund manager requires additional homework compared to buying an index,” Wieczorek said. “However, if chosen correctly, an active manager can add significant value to your portfolio over the long term.”
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