13 Oct Buy index or actively-managed funds?

Q. I’m all in index funds but I’m afraid the market isn’t going to keep going straight up. Is there an advantage to using higher-cost actively managed funds, or should I stick with the index funds?
— Investor

A. The stock market never moves in a straight line, however lovely the last many months of upward movement has been.

Equity index funds are a great way to get stock market exposure without having to pick individual stocks or an active manager, said Frani Feit, a certified financial planner with Tradition Capital Management in Summit.

But, she said, you are getting just that: all the same ups and downs and returns right along with the market.

You said you’re in index funds, but which indices do they track? There’s the S&P 500, or the Russell 2000, which tracks 2,000 small cap companies, or the Russell 3000, which tracks the largest 3,000 companies — and more.

Then with each index, you need to think about how the index is constructed, she said.

“The S&P 500 is a market capitalization weighted index, which means a company’s percentage weighting in the index is based on its number of shares outstanding multiplied by its share price,” she said. “By contrast, the Dow Jones Industrial Average is a price weighted index, where only its price per share for each stock determines its weighting.”

Then there are active managers, who study and research the underlying fundamentals of a company to identify undervalued stocks compared to their benchmark.

“Active management can also help control `downside capture,’ the amount a portfolio of stocks will fall in contrast to its index,” Feit said. “Since managers can choose higher quality stocks, focus on more defensive sectors of the market or raise cash in their portfolios, their downturns may not be as severe as the overall index.”

And we all know that if your money decreases less, you have a shorter climb back up to where you started.

There can be tax advantages to owning individual stocks instead of index or actively-managed funds.

“A portfolio of individual stocks can be tax loss harvested to help offset any realized gains you may have,” Feit said. “That means selling some of the positions that may be at a loss and using those losses to offset other gains to control the amount subject to taxes.”

An index fund won’t provide that same individual stock flexibility, she said. When you sell some of your shares in an index fund, you will either have a gain or loss on that amount.

And then there are fees.

“As you can imagine, index funds are cheap, as you are buying a replication of an index,” she said. “Actively-managed funds typically have higher fees, because of the research and portfolio management costs.”

Feit said you can look for a balance. This is what some financial professionals are calling a “core and satellite strategy.”

By layering active management in equities (the satellite) over a core holding of index funds, investors can maintain market exposure and returns — in a year where the active manager might lag — and also avail themselves of the active manager’s downside capture and increased returns during years of outperformance, Feit said.

She said her company has a 17-year-plus track record of producing above-average risk-adjusted returns in its individually managed equity portfolios.

“These portfolios serve as the core and, if appropriate to meet a client’s objectives, we complement the actively managed holdings with index funds,” she said. “Equities, whether in index or actively managed funds, are an integral asset class in well diversified portfolio and essential in protecting and growing wealth.”

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This post was originally published in October 2017.