Index Fund or Active Manager?

There's no easy answer in these times, but diversification may be the best answer in either case
Barry Falls

In a time of financial crisis, what's the least painful place for an individual investor: a slumping index fund or a staggering competitor that's actively managed? Sadly, there's no simple answer.

Most active managers trail the indexes over the long term, especially when you count the added trading costs of active management and index funds' lower fees. But some pros argue that there are times—and now may be one of them—when the market's extreme volatility favors a hand on the helm. A prescient manager might have avoided financial stocks before they plummeted, and might be able to spot bargains in coming weeks while panic has others fleeing.

But only the right manager, chosen at the right time, will put you ahead of the pack. Some experts without a personal stake in the matter maintain that it's unlikely you'll have the savvy to make this choice. "I think the arguments for indexing hold even more so now," says Stuart Michelson, a finance professor at Stetson University in DeLand, Fla. "Active managers have a very hard time outperforming the index funds. In turbulent markets, where it's even harder to figure out what's going on, I would put a lot more faith in an index over an active manager."

Many fund managers, Michelson notes, loaded up on financial stocks just before the financial crisis and have cost investors far more than they would have lost by following the broader market. Clipper Fund (CFIMX), a well-regarded actively managed value fund, had 10.5% of assets in AIG (AIG) and Merrill Lynch (MER)—and is down 30.1% year to date, according to research firm Morningstar (MORN).

We asked Morningstar to crunch numbers on actively managed large-cap funds vs. the Standard & Poor's 500-stock index following five market meltdowns since the October 1987 stock market crash. (The others were the late-1980s savings and loan crisis, the 1998 bailout of Long-Term Capital Management, the dot-com crash of 2000, and the September 11 terrorist attacks.) The result: a bit of a muddle.

In some cases, active management proved a winner; in others, the index held its own. "When you look through these five previous financial crises, they don't really support the notion that active management is superior in a time of crisis, which is a theory that is often advanced," says John Rekenthaler, Morningstar's vice-president of research.

The picture may be different if you choose the ideal manager, he says. Sequoia Fund (SEQUX), which has an outstanding long-term track record and a large holding in Warren Buffett's Berkshire Hathaway (BRK.A), was well ahead of the indexes five years after each crisis, according to Morningstar. Closed to new investors for more than 25 years, Sequoia reopened in May.

Most investors, however, don't pick great managers and stick with them. That's why Larry Swedroe, director of research at Buckingham Asset Management in St. Louis and author of Wise Investing Made Simple, thinks it's a fool's game to try. "You're better off abandoning hope of beating the market," he says. At a time like this it's especially vital to build a portfolio out of the best and lowest-cost passive funds, he adds. And don't rely just on an S&P 500 fund.

In fact, diversification generally may be more important than whether you choose actively managed funds or indexes. William Goetzmann, a professor of finance at the Yale School of Management, says that the past two weeks don't provide any rationale for rethinking your basic assumptions. "I don't see any big reason to change your mind about stock indexing because of the crisis," Goetzmann says. He's long been hedging his own bets by investing the bulk of his money in index funds and a slice in actively managed ones. "I believe a little bit in skill," he says, "but I like that this index I am invested in has generated an equity premium over the long term."

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