Active fund management is where the portfolio is chosen by a manager or a team and then monitored and adjusted with the objective of beating a predetermined benchmark. Passive fund management is structured to mirror an index or some other criteria with little or no changes. Which type of fund management is best?
Passive fund management has some important advantages from the start. Internal fund costs are generally lower. Tax costs are usually lower because turnover is less. Passive funds are quick to point out that historically the average fund manager has failed to beat their benchmark.
It is also true that historically about 25% of active fund managers have beaten their benchmark. We should not blindly ignore active fund managers. The problem for most investors is created by trying to pick which fund manager is going to outperform.
We believe that a properly diversified portfolio will contain both active and passive funds. When choosing actively managed funds, start by looking for a solid risk-adjusted performance history and verify that the manager and selection process that produced these results are still in place. Actively managed funds should be held in qualified accounts to minimize current income taxes. Passively managed funds should be held in taxable accounts.
The final ingredient is to have a disciplined process for making changes to your portfolio. Managing a portfolio of mutual funds is not like managing stocks. You don’t need to be quick to sell to avoid a position sinking the ship. Changing a fund should be a thoughtful process otherwise you fall victim to chasing performance and the latest hot trend. The portfolio needs to maintain diversification which means that something will be out of favor all the time. Your sell discipline needs to include measuring performance against peer groups, not just benchmarks.
A clearly defined investment strategy should be in place before you begin choosing funds. This strategy will include a clear buy and sell discipline. Afterwards you can choose from the entire universe of active and passive funds to build your portfolio.