What Are Actively Managed Funds?

Actively managed funds rely on trading decisions to boost returns

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An actively managed mutual fund, or exchange traded fund (ETF), is one that relies on the decisions of an investment manager or a team of managers to select the fund’s holdings. The objective is to outperform passively managed mutual funds, which match and track an index of holdings such as the Standard & Poor’s (S&P) 500 or the Nasdaq Composite Index.

Managers of actively managed funds typically adhere to an investment strategy that is defined in the fund prospectus, but they have the flexibility to purchase and sell investments based on their research.

Although actively managed funds account for the majority of long-term fund assets—approximately 60% at the end of 2020—index funds have more than doubled their share of long-term fund assets since 2010. Passively managed funds have grown in popularity as more investors learn that these funds broadly outperform actively managed funds and carry lower management fees and costs related to portfolio turnover than actively managed funds.

Definition and Example of Actively Managed Funds

The managers of actively managed funds seek to take advantage of market inefficiencies through analytical research, forecasts, and their own judgment to outperform funds that simply track a market index.

The concept of investors pooling their money to have someone else invest on their behalf was introduced in the U.S. in 1893 by the Boston Personal Property Trust. Investments in that initial fund were more real estate-based than stocks or bonds. The first actively managed fund that more closely resembles today’s stock and bond mutual funds was the Alexander Fund, which was introduced in 1907.

The popularity of mutual funds waxed and waned through the Great Depression and for several more decades. As the country rebounded from the stock market crash of 1929, the U.S. Congress created the Securities and Exchange Commission (SEC) in 1934 to protect investors from fraud and unfair sales practices, a role the SEC performs to this day. The mutual fund industry grew through the decades, and index mutual funds were introduced in the 1970s. But actively managed funds commanded the spotlight during the bull market of the 1980s and 1990s. Fidelity’s Peter Lynch, who managed the company’s Magellan Fund from 1977 to 1990, averaged annual returns over 29% during that time.

Fidelity, like many mutual fund companies, now offers both actively managed funds and index funds.

ETFs emerged as alternatives to index funds that mostly follow indexes and charge low fees, but there are some actively managed ETFs that are not locked into tracking an index.

How Actively Managed Funds Work

Investors who wish to attempt to outperform market indexes may choose to select their own stocks or invest in actively managed mutual funds. Some investors invest in both index funds and actively managed funds.

Managers of actively managed mutual funds are usually supported by a team of investment analysts. The performance of an actively managed fund is usually measured against a benchmark index that most closely mirrors the fund’s investment strategy. Performance over various periods, such as one, three, and five years, can be found in the fund prospectus. The prospectus also will list management fees and provide information on the fund managers, including how long they have managed the fund.

For example, the prospectus for the Fidelity Magellan Fund (FMAGX), which was a high flier when managed by Lynch, shows that at the end of October 2021, it had returned just under 38% in the last 12 months and had an annual average return of about 21% over five years. Its benchmark, the S&P 500, however, had returned almost 43% in the same one-year stretch and had an annual average return of slightly less than 19% over the past five years.

The majority of actively managed mutual funds fall short of beating their benchmarks. S&P Indices vs. Active (SPIVA) research scorecards published by S&P Dow Jones Indices compare the performance of actively managed equity and fixed income mutual funds against their benchmarks. The company reported that about 73% of actively managed U.S. large-capitalization equity funds have underperformed the S&P 500 over the past five years. Over that same five-year time period, almost 67% of actively managed small-cap equity funds underperformed their benchmark, the S&P SmallCap 600.

Pros and Cons of Actively Managed Funds

The debate over whether actively managed funds are better than passive funds will likely continue among investors forever. However, there are positive and negative facts about actively managed funds that can’t be disputed.

Pros
  • Provide middle-income investors access to professional stock pickers

  • Can outperform benchmark indexes over short and long terms, sometimes by a significant amount

  • Management fees have decreased in recent years

Cons
  • Most underperform benchmark index funds

  • Past performance is not an indicator of future results

  • Typically have higher fees and additional costs related to trading

Pros Explained

  • Provide access to professional stock pickers: Many fund managers have years or even decades of experience and usually deep teams of analysts to help them choose stocks.
  • Can outperform benchmark indexes: Fund managers aim to outperform their passively managed benchmark index funds by conducting thorough research and attempting to take advantage of market inefficiencies.
  • Management fees have decreased: Morningstar reported the average actively managed fund’s average expense ratio for investors has fallen by more than half since 2000. From 2016 through 2020, the average expense ratio for active funds declined 11% while the average fee for passive funds dropped by 12%.

Cons Explained

  • Most underperform their benchmark index fund: It’s a fact that a majority of actively managed funds underperform their benchmark index. It’s common for more than 70% of actively managed U.S. large-cap funds to underperform their benchmarks.
  • Past performance is not an indicator of future results: Every prospectus will tell you as much. Even when a management team works together for years, the performance of actively managed funds can vary widely from year to year when measured against their benchmarks.
  • Higher fees and other costs: Even though index funds with generally lower fees have put pressure on brokerages’ fund families to lower the cost of their actively managed funds, the latter routinely have higher costs than index funds.

What It Means for Individual Investors

There are varied opinions about whether it makes sense to use actively managed funds when most underperform their benchmarks and charge more in fees. Some investors use actively managed funds for specific sectors, such as biotech or real estate, and go with index funds for broader holdings such as large-cap or international equities.

Most brokerages provide easy access to a wide range of both actively managed and passive funds. When choosing actively managed funds, it is important to conduct thorough research about the management team as well as the fees and costs associated with any portfolio, its trading turnover, and its operations.

Key Takeaways

  • Actively managed mutual funds, or ETFs, rely on the research and decisions of an investment manager or a team of managers to select the funds’ holdings.
  • The performance of an actively managed fund is usually measured against a benchmark index that mirrors the fund’s investment strategy.
  • The majority of actively managed funds underperform their benchmark indices over time.
  • Because of their style of management, actively managed funds routinely have higher costs than passively managed index funds.