Best Mutual Fund Types for Active Management

When Index Funds May Not Have an Advantage

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Actively-managed mutual fund managers can dig up some of the best investing opportunities. Getty Images

Without a doubt, index funds are the best overall investments in terms of average annualized returns over long periods of time. But there are certain investment types and mutual fund categories where an active management style can do as well or better than passively-managed funds.

Therefore indexing has its strengths and weaknesses. This article will focus on the weaknesses, which is where the strengths of actively-managed funds can prove beneficial.

But First a Word on Efficient Markets

The Efficient Markets Hypothesis (EMH) essentially says that all known information about investment securities, such as stocks, is already factored into the prices of those securities. Therefore no amount of analysis can give an investor an edge over other investors.

However, investment experts disagree on the efficiency of markets. And there may be exceptions. For example, a "weak form" of EMH that suggests that fundamental analysis of securities can provide an investor with information to produce returns above market averages.
 

Best Investment Types for Active Management

The basis of EMH is that investors cannot gain an edge over other investors if all the available information about investment securities is already priced into the securities. But some securities have more information available to the public than others. Therefore, the less that is known about an investment type, the better the case for active management (and therefore not as strong of a case for passively-managed index funds).

Here are some of the fund types that can perform better than index funds, especially over short periods of time, such as less than 5 years:

  • Small-Cap Stock Funds: The smaller the company, the easier it can be for a resourceful fund manager to produce returns above a broad market index for small caps, such as the Russell 2000 Index. Warren Buffett once said, “It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.” What he means is that smaller can be better for a skilled asset manager. Therefore picking a good small-cap fund manager can be better than using a small-cap index fund.
  • Emerging Markets Stock Funds: Emerging Markets are countries with rapidly growing economies but are generally "less developed" than the largest nations in the world such as the United States and those of western Europe. Some of the largest countries considered to be emerging markets include China, India, Russia, Brazil and Mexico. These countries may carry political risk or unrest, questionable accounting standards or unstable currencies. However, the higher relative risk is thought to provide higher potential returns because of opportunities uncovered by resourceful active managers.

See Also: Best Fund Types for Indexing

Disclaimer: The information on this site is provided for discussion purposes only, and should not be misconstrued as investment advice. Under no circumstances does this information represent a recommendation to buy or sell securities.