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Keep Fees Low, Hopes High

By James G. Mentzer D’99

This article represents the personal views of the author and should not be considered either professional tax or legal advice. If you have questions concerning your own situation, please consult a personal adviser.


Say what you will about the Financial Meltdown of 2008 - it has challenged all the classic understandings of personal investing. Systematic re-balancing, 401(k) plans, and well-diversified asset allocation programs are all under close scrutiny in light of the tremendous losses experienced by investors last year.

No investing concept, though, has been criticized more than actively managed investment funds. Whether purchased for personal investment portfolios or as part of a retirement plan, funds actively managed failed to offer significant added value when financial markets began to tumble in late 2007.

As the markets now begin to rebound, many are turning to passively managed funds — index funds — as a lower-cost option. The Wall Street Journal on June 22, 2009, reported that numerous large institutional investors were shifting dollars to cheaper, passively-managed index funds rather than continue to pay a premium for active management.

Should everyday investors follow the lead of these pros? Many have long considered index funds the logical way to invest, and not just because they are cheaper. Indexing requires little time or expertise. Simply pick a mutual fund that mimics one of the broad indexes, say the Standard & Poor’s 500-stock index or Barclay Capital’s U.S. Aggregate Bond Index, and you’re ready to go. Your investment portfolio will never outperform the chosen index, especially after fees are subtracted. However, and this is key, you’ll also never sharply underperform the index. Combine this consideration with the reality of lower investor fees and index funds appear to be the way to go.

Ironically, performance reports do not always support this argument. According to Morningstar, from Oct. 9, 2007, when the Standard & Poor’s 500 index topped out at 1565, until this same index tanked at 682 on March 5, 2009, index funds actually under-performed their active counterparts. During this 17- month period, passive funds lost 45 percent on an annualized basis while active funds were down 43.5 percent. However, since the Standard & Poor’s 500 index began its climb on March 5 of this year, active funds have gained 37.7 percent in value, while index funds are up 41 percent through mid-year.

Why the differences? During the free-fall market conditions last year, index funds remained fully-invested to mimic their respective market index. Actively managed funds, though, had the freedom to take defensive actions, such as selling poor-performing companies and holding the proceeds until the market began to recover. Thus actively managed funds had the potential to better weather the storm.

However, once the market began its rebound this spring, the opposite effect kicked into gear. Actively managed funds were often timid and missed the opportunity to reinvest cash assets at the very beginning of the recovery. Index funds, mandated to invest in market assets come good times and bad, did not have this problem. When upward swings occurred, index funds participated fully in gains.

If one can earn similar returns with index funds, does it make sense to pay more in fees for an actively managed fund? Yes and no. Many analysts believe that in the next five to seven years, financial markets will experience a maddening series of short peaks and valleys rather than upward momentum.

Faced with possible flat market conditions, investors might seek investments that are actively managed by those with proven ability to find hidden values in stale market conditions. The key will be to focus on the fund manager’s history. First, how has the manager performed in past times when the market was stagnant? While past performance is never a guarantee, it will give you a sense of how such a manager might perform in future months.

The second consideration is fees — what does the fund manager charge investors to participate? With the growing number of no-load and institutional share investment funds today, there is no reason to pay a premium for active management.

Keep your costs low and your expectations high. In the long run, skipping the passive for the active may still be better for your portfolio.

James G. Mentzer, CLU, ChFC, has been a financial planner since 1985. He is currently director of planned giving for the United Methodist Foundation of Raleigh, N.C.