The Advantages and Disadvantages of Actively Managed Mutual Funds

Actively managed mutual funds use an experienced fund manager or management team to select stocks and bonds actively, usually at a more significant expense than passive investing strategies.

These expenses, such as investment manager salaries, bonuses, and office space costs, are included in the fund’s expense ratio and can erode returns over time.

Strategy

Actively managed mutual funds aim to outshine their respective investment categories and benchmark indexes. To do this, fund management teams handpick individual investments to find companies with the potential and commitment to increase dividends over time. For instance, Vanguard Dividend Growth (VDIGX) featured on our Money 50 list, employs professional stock pickers that use “bottom-up fundamental research to identify high-quality businesses that possess both potential and commitment in increasing dividends over time.”

Passively managed mutual funds seek to closely follow an index by purchasing all or a representative sample of its stocks and bonds, using financial analysis tools that predict likely market performance. Unfortunately, all this work takes up valuable human time and expensive tools – therefore, active funds typically charge higher fees than passive ones.

Active fund managers offer several advantages over passively managed funds, including greater flexibility to buy and sell securities as they see fit, use hedging techniques to minimize losses while increasing gains, and are not restricted to following any particular index; thus searching out “diamonds in the rough” stocks that may outshine overall market performance.

Unfortunately, actively managed funds do not typically outshine the market over the long haul. A recent report from Morningstar discovered that only 26% of equity funds outperformed their benchmark index, while four bond categories and none of the U.S. large-cap stock funds managed this feat.

However, an actively managed fund may still be worthwhile if you want to diversify or add variety to your current mix of investments. Just ensure your active manager has an established track record that proves they possess both skill and luck when selecting investments for you; also, be prepared for potential underperformance in bear markets.

Risk

Active funds offer investors the benefit of professional expertise. Fund managers possess years of experience and conduct in-depth research across different markets and sectors, giving them a deeper insight into each company’s financial results and business model that may otherwise be difficult for individual investors to grasp.

Hands-on approaches mean managers can purchase securities based on an internal investment process rather than following predefined rules, providing investors with more sophisticated returns than index-trading ETFs can provide. Unfortunately, this comes at the cost of increased market volatility exposure for fund managers.

Before investing, investors must assess their risk tolerance. This involves considering their time commitment to investing, their patience with risk and investment objectives, and any illiquidity issues with any fund that might arise.

One of the critical risks associated with actively managed mutual funds is underperforming and losing money as promised if their fund manager fails to deliver on his or her promise of outperformance. This risk is commonly known as selection risk; an overperforming active fund must compensate for an underperforming passive fund within a portfolio to produce overall positive returns.

Active managers face another risk in that mistakes made by active managers could negatively affect their performance. A recent study discovered that U.S. large-cap equity funds missed their market index benchmark 88.4% between 2013 and 2018, small-cap funds missed it 89% of the time, and international small-cap funds often fell short by 80-90%.

Active managers also risk being exposed to higher levels of risk through concentrated holdings in particular stocks or sectors than index-trading ETFs, for example, if their fund manager heavily invests in value stocks, energy companies, or commodity firms, which could result in price bubbles and wasteful capital allocation decisions which do not generate the best long-term returns for investors.

Fees

Actively managed funds may present investors with significant disincentives to investing. Fees charged as a percentage of total assets accused to pay for management, distribution, and marketing expenses of these active funds tend to be significantly higher than for index-tracking mutual funds; investors who opt for actively managed funds should speak with their financial advisor about investing instead in index-tracking mutual funds to reduce these fees possibly.

One of the more commonly levied fees against actively managed mutual funds is their management fee, which pays for professional investment services provided to the fund. This percentage fee covers professional management of its portfolio and may even be higher with more specialized funds.

Many funds impose a sales load fee, an upfront charge subtracted from the purchase price of shares. It usually peaks when first purchasing, then gradually declines; some funds offer reduced sales loads on larger purchases through breakpoints.

Some funds also charge redemption fees when selling shares; these costs may range from days to more than a year after selling and are often higher for funds with high turnover rates.

Investors considering active mutual funds must also carefully consider their tax obligations. Aside from management fees and sales loads, capital gains taxes could apply to the earnings of an actively managed fund. Prospectus reviews should be done to assess a fund for potential taxable capital gains before speaking with their financial advisor about any possible tax ramifications from adding these funds into a portfolio.

Some investors might believe that actively managed funds’ higher fees are justified by their increased returns; however, in the long run, higher prices may hinder returns – particularly if your fund attempts to beat the market with riskier stock-picking strategies requiring compensation from managers for risk-taking and stock selection.

Performance

When considering whether or not to invest in an actively managed mutual fund or index fund, it’s essential to assess any differences in return between them. While index funds aim to mirror an underlying market’s performance by tracking it with its index funds, active managers can try and beat that benchmark through riskier strategies or different investments selection. While this often means higher fees but may lead to outperforming its index counterpart.

Active funds are managed by teams of research analysts and portfolio managers who make real-time adjustments to reflect changes in market conditions, such as by increasing or decreasing exposure to specific sectors, countries, or individual stocks based on their analysis of the economy. Some active fund managers believe tracking an index is detrimental for investors because it reduces participation opportunities during anomalous market trends like the dot com boom of the late ’90s when tech stocks reached record heights.

Actively managed funds vary significantly by manager, asset class, and category. On average, most active funds lag their benchmark index compared to passive peers; however, this figure can change considerably yearly; for instance, in 2022, approximately 80% of actively-managed U.S. large-cap equity funds underperformed their benchmarks, one of the worst performance records ever.

Foreign stock, real estate, and bond funds have higher success rates. Furthermore, several studies suggest that investors who hold actively managed funds for ten years or longer are more likely to attribute their performance to skill than luck, as noted by Jeremy Siegel, professor of finance at Wharton School at the University of Pennsylvania.

Many experts contend that active management‘s poor long-term success rate indicates it’s time for passive strategies, while others disagree and maintain that industry implementation of an alternative investment vehicle could take years; until that occurs, active funds may still present an attractive option to investors.