Vanguard enjoyed a tremendous year in 2014 with $233 billion of inflows into its mutual funds, according to Morningstar Inc. (MORN). Vanguard, of course, is well known for its stable of low cost index mutual funds and exchange-traded funds (ETFs). Moreover, Morningstar’s data indicated that passively managed index funds pulled in over $156 billion in assets collectively over the past 12 months, as of the end of November, 2014 . By comparison actively managed funds experienced more than $91 billion in outflows during the same time period.

The reasons for this trend over recent years are pretty clear. In 2014 the Standard & Poor's 500 Index gained 13.7%. Only about 12% of the large growth fund managers tracked by Morningstar managed to beat the index. Add to this that many of these active funds that underperformed the index also threw off large year-end distributions adding insult to injury for investors holding the funds in a taxable account. (For more, see: The Lowdown on Index Funds.)

Should investors just eliminate actively managed funds from their portfolio?

Some Active Managers Add Value

Looking at this another way, the example above indicated that 88% of large growth managers underperformed the S&P 500 Index in 2014.  However, 12% did outperform the index. The key is doing the work and the analysis to find the managers who are likely to outperform on either/or a raw or risk-adjusted basis. This is an admittedly difficult task, but investors also need to look past a one or two year time horizon. (For more, see: Passive vs. Active Management.)

As an example, a hypothetical $10,000 investment in the Sequoia Fund (SEQUX) made on December 31, 1970 would have grown to $4,185,709 as of December 31, 2014. This is an average annual gain of 14.54%. By comparison a similar hypothetical investment in the S&P 500 (if this were possible) would have grown to $1,025,052, an average annual gain of 10.52%.

Legg Mason Inc.'s (LM) Bill Miller had an amazing run where he beat the S&P 500 for 15 straight years ending in 2005. From 1977 through 1990 legendary manager Peter Lynch led Fidelity Magellan (FMAGX) to an average annual gain of over 29%.  (For more, see: The Greatest Investors: Bill Miller.)

One downside of an actively managed fund is the need to monitor the manager. In the case of Magellan it never reached the levels of performance achieved by Lynch since his departure. In the case of Miller he has had a couple of good years since 2005 but nothing like his 15 year streak. 

Better Than An Index Fund?

Ask yourself if you would invest in an actively managed fund over an index fund in the same asset class. As mentioned above this is a very valid question in a number of core asset classes. Providers like Vanguard and Blackrock Inc. (BLK) offer a wide range of index mutual funds and ETFs that rank quite well in many asset classes and outpace a majority of their actively managed peers in many cases. (For more, see: Active Management: Is it Working for You?)

Is The Herd Right?

In the late 1990s we were told that high-flying tech stocks with little or nothing in the way of a balance sheet were fine investments because it was different this time. As we all know they were not. Real estate was touted as a solid even safe investment. As we learned during the financial crisis maybe this isn’t the case.

I’m not saying that index funds will crash and burn, but at some point I suspect active management will have its day again so to speak. What will be interesting is how investors react the next time that “stock picking” is back in vogue. Will a good deal of the inflows we’ve seen into index funds flow elsewhere? (For more, see: Index Mutual Funds vs. Index ETFs.)

People and Process

When evaluating an actively managed fund it’s all about the people and the investment process. We discussed the importance of who’s managing the fund above. The investment process is critical as well. At least a couple of the actively managed funds I’ve used successfully over the years have experienced turnover in management and key personnel. What kept these funds successful and allowed them to continue to achieve solid results for their shareholders was the continuation of the investment process that had made the fund successful in the first place. (For more, see: Understand Your Role in the Investing Process.)

Index Funds

The use of index funds can be an active strategy via the use of asset allocation. Investors make decisions as to how to weight their portfolios in terms of asset classes and the use of index funds is a great way to implement an allocation strategy. (For more, see: Should I Invest in ETFs or Index Funds?)

Index funds come in many shapes and sizes. Beyond core indexes like those tracking standard indexes across various asset classes there are a number of index funds and ETFs created on a regular basis that track benchmarks with little or no actual history that were essentially created on someone’s computer.

Additionally not all index products are dirt cheap. It is important to check expenses before investing. (For more, see: Stop Paying High Mutual Fund Fees.)

The Bottom Line                                                                                                                              

Should investors eliminate actively managed funds from their portfolio? In my opinion the answer is no. That said investors and financial advisors need to be diligent in their process used to select, monitor and when needed replace active managers. Additionally an active manager needs to earn their keep so to speak. Can they truly beat their benchmark over time?  What else do they add to the portfolio other than raw performance? Are the expenses reasonable?

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