Active vs. Passive - Choosing Funds for your Portfolio? | Rodgers & Associates

How We Choose Funds for our Clients’ Investment Portfolios

The Dow Jones Indus­trial Average has just passed 23,000 as I am writing this newsletter. Clients typically ask if there are any good places to invest, and this topic comes up more frequently when the stock market is making a new high. Rather than talk about the typical cycle of the market, I want to focus this newsletter on investment selection. Specif­i­cally, how we choose funds for our clients’ portfolios.

Anyone who has ever read a mutual fund adver­tisement has probably noticed the disclaimer “Past perfor­mance is no guarantee of future returns.” A study[1] by Standard & Poor’s found that only 5% of funds in the top 25% of their category for the past year manage to stay in the top 25% three years in a row. If not perfor­mance, what criteria should be used?

Criteria We Use to Choose Funds


Mutual funds cost money to run and admin­ister. Even passively managed index funds have expenses. We look at the expense ratio of a fund and compare it to the category average. Our objective is to select the fund with the lowest possible expense ratio for our clients if all else is equal. Expenses are shown in mutual fund data as a percentage of assets. If two mutual funds investing in the same category have expense ratios of 0.50% and 1.5%, respec­tively, the chance of the second fund outper­forming the first fund consis­tently by a full percentage point each year is remote.

Turnover cost

The cost of trading positions within the fund is not included in the expense ratio. This cost is a drag on perfor­mance and creates additional expense in the form of taxes for a fund held in a taxable account. Trans­action costs have been estimated[2] to generally average 0.6%. A fund with a turnover ratio of 100 has an estimated trading expense of 1.2%, 0.6% to sell every­thing, and another 0.6% to replace the positions. All things being equal, we choose funds with low turnover to minimize expenses.

Broad diversification

We diversify portfolios over different asset classes by choosing a fund to represent a specific asset class. Therefore, the fund we select must be broadly diver­sified within the asset class. We avoid funds that are concen­trated within an industry or an individual company. We also avoid funds that use leverage which increases risk and volatility.

Active management vs. passive

Passively managed funds (often referred to as index funds, although not all track an index) have a lot of advan­tages. The average expense ratio of a passive fund is 0.11%, while the average for actively managed funds is 0.84%[3]. Passively managed funds typically have low turnover and are therefore more tax efficient. Most passive funds are broadly diver­sified as they attempt to track an index that is specific to an asset class. Why invest in anything else?

In reality, actively managed funds may bring signif­icant benefits when used properly in the construction of a portfolio. Actively managed and passive index funds are comple­mentary when used together.

Generally, active funds do better than passive funds when markets are ineffi­cient[4].

A skilled manager can take advantage of illiquid and data-inefficient markets, where mispricing of securities can be frequent and the rewards usually more substantial. Some who believe index funds are the only way to invest believe there are few ineffi­ciencies in today’s market. This may be true of large cap stocks. However, markets for small-cap and microcap stocks can be ineffi­cient due in part to scarce guidance by analysts. This is where we have found active management to work well for our clients’ portfolios.

Inter­na­tional and devel­oping markets are other areas where we might find market ineffi­ciencies. Diver­si­fi­cation across inter­na­tional markets is essential to proper asset allocation. A blanket approach using index funds doesn’t usually take advantage of unique oppor­tu­nities that arise within the inter­na­tional markets as effec­tively as a skilled fund manager.

Periods of market stress also appear to favor active management over passive. A study[5] by Fidelity Invest­ments found that actively managed funds do better when markets are under pressure. This actually makes perfect sense. One of the reasons passively managed funds typically do better over time is because the stock market goes up over time. Passively managed funds must stay 100% invested in order to track their index. According to an article in Barron’s[6], actively managed funds are rarely 100% invested. The average cash position of actively managed funds was 3.6%. Cash would hold back the perfor­mance of a fund when the market is going up. However, cash would be quite helpful when the market is going down. The Fidelity study also concluded, “We think this outper­for­mance is likely due to active managers’ ability to select market-beating stocks even when the market is going down, or to reduce losses by holding lower stock exposure before a sell-off.”

In conclusion, passively managed funds have important advan­tages and play a central role in portfolio construction for many reasons. Actively managed funds are also an important tool and, when used together with passive funds, have the potential to minimize risk.

Rick’s Tips:

  • All funds have expenses. Expense ratios are an important tool to compare two funds with the same investment strategy.
  • Trading costs are not included in expense ratios. You must look at turnover to estimate this cost.
  • A recent Fidelity study found that actively managed funds generally performed better than index funds in down markets.

[1]Does Past Perfor­mance Matter? The Persis­tence Scorecard. By Aye M. Soe, CFA. S&P Dow Jones Indices, June 2014.
[2] Bogle On Mutual Funds: New Perspec­tives For The Intel­ligent Investor. By John Bogle. Wiley Investment Classics. April 2015
[3] Source: Index Funds vs. Mutual Funds. By Jordan Wathen. The Motely Fool. August 2016
[4] The Experts: When Does Active Management Make Sense? The Wall Street Journal. April 2013
[5] Rocky markets and the power of active funds. Fidelity Viewpoint. August 2017
[6] For Mutual Funds, How Much Cash Is Too Much? By Lawrence Strauss. November 2014