The New York Stock Exchange (NYSE) in New York, United States, on Tuesday, March 28, 2023.
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As investors navigate another uncertain year in markets, actively managed funds could provide differentiated performance to their portfolios — if traders choose carefully.
Actively managed funds have historically underperformed passive strategies, but 2022 has been a better year than most for stock pickers. According to S&P Global’s SPIVA US Scorecard, only a slim majority of large-cap equity fund managers underperformed their benchmarks over the past year. The company noted that this was the lowest underperformance rate for the category since 2009.
Surely that’s hardly a ringing endorsement. Investors can easily face high fees as well as capital gains taxes, making many actively managed funds poor alternatives to passively managed strategies that can mimic a benchmark at a lower cost.
Still, actively managed funds may have a better chance of outperforming during times of volatility. They also beat passive strategies in some less risky categories for investors other than US large-caps, according to S&P research.
An actively managed exchange-traded fund called the JPMorgan Premium Equity ETF (JEPI) has a yield of 9.59%, which is attracting investors to the ETF. It currently has inflows of more than $7 billion this year, according to FactSet data.
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For Jennifer Bellis, private wealth advisor at US Bank Wealth Management, what matters is what the investor is trying to achieve. Actively managed funds can help diversify portfolios, but investors need to do their due diligence, she said.
“It’s more about finding the right manager and the right strategy,” Bellis said.
This is how investors should proceed when deciding whether they should include actively managed funds in their portfolio – and what they should look out for when making the decision.
A good track record is key
For investors evaluating actively managed strategies, a manager’s track record is the first place to start. A strong track record of performance over three, five and ten years can show you how the funds and their methods have performed over different market cycles – particularly when different investment styles have tumbled on and off.
“Anyone can have a good year,” Bellis said. “So what you want to do is research the fund and the manager and look for a track record. Ideally, a 10 year history review is what you are looking for.”
Investors can also review managers and their teams, as well as their tenure with the fund. You can also carefully review the fund’s holdings to assess how the selection compares to its benchmarks. A fund that tracks an index too closely may not generate differentiated alpha and may look like a passive investment.
Even successful managers can have a bad year, as past performance is not necessarily indicative of future success.
Look for lower fees
Of course, investors need to weigh up whether an actively traded fund is right for them.
For newer, less well-capitalized investors, passive instruments could offer them the opportunity to build wealth at a far lower barrier to entry – rather than the typically higher fees and capital gains taxes and research that come with active managers.
Actively managed funds typically charge an expense ratio between 0.5% and 1%, but expenses can go as high as 1.5%, according to Investopedia. Meanwhile, passive index funds average about 0.2%. Other fees that could be attached include 12b-1 fees, which are marketing expenses.
“These fees are not necessary,” Bellis said. “So you want to make sure you check the prospectus to make sure you don’t have those front and backload fees because there are a lot of funds that don’t have them. There’s no reason to pay them.”
Pay attention to diversification
Investors also need to consider where they want to apply active strategies in their portfolio, such as emerging markets or small caps.
“These markets are so broad and contain so many ideas that I think an active manager who follows these markets and scans the fundamentals can exploit some of the inefficiencies or find interesting ideas,” said Kathy Carey, Director of Asset Manager Research at Baird.
Notably, small caps had the lowest underperformance rate among US stocks over the past year, according to the S&P Global scorecard. Only 40% of active funds in domestic small caps underperformed.
Carey also said investors looking for exposure to more specific emerging market ideas outside of China might have better luck with an actively traded strategy, Baird’s Carey said.
Other interesting strategies within actively managed funds include long-short and total return strategies, according to Bellis. A long-short strategy is favored by hedge funds trying to take bets on preferred stocks while betting against stocks that could fall. A total return strategy focuses on generating income for investors.
According to Baird’s Carey, investors can assess where active strategies could differentiate their portfolios.
“Active managers, in turn, have the opportunity to find out where the market is going.” said Carey.