Time to Take Action?

After the bear market wreaked havoc on your investments, did you kick any loser funds to the curb in favor of a simplified portfolio? If so, you're not alone. The trend to eschew actively managed mutual funds in favor of low-cost index funds has intensified during the recession, with investors adding more than $253 billion in funds with "passive" investing strategies since the end of 2007, vs. $72 billion taken out of active funds. In the first half of 2009, almost $22 billion in new cash was added to equity index funds, vs. $20 billion in net outflows for active stock funds. At the current rate, index funds will have amassed nearly 55% of all fund assets by June 30, 2019, up from 18% a decade earlier, according to data from Financial Research Corp.

The shift is understandable—actively managed funds lost more than index funds in 2008. But the timing is poor: Right now, there's a surprisingly strong case to be made for buying into actively managed funds.

The main argument is simply that the bargains are better than ever—even with the Standard & Poor's 500-stock index up 52% from its March low. Research published in May by Boston Company Asset Management, a subsidiary of BNY Mellon (BK), found the downturn that dragged the S&P 500 near a 13-year low also had a big effect on valuation spreads, or the difference between where the cheapest companies in the index trade relative to the overall average.

Across most sectors, these spreads widened to levels not seen since 1952, presenting once-in-a-lifetime buying opportunities for active fund managers to load up on high-quality, heavily discounted stocks. Lately, some valuation spreads are looking even more attractive. And historically, active managers have most consistently outperformed following periods such as this, according to the report.

At the market bottom this past March, the average price-earnings ratio of companies in the S&P 500 was 10.0, vs. 3.9 for the 100 cheapest stocks in the index—a spread of 6.1. The spread currently tops 9.6 as disappointing earnings reports, coupled with rising stock prices, widened the range between the cheapest and most expensive S&P 500 companies. The p-e's for some S&P companies, including Abbott Laboratories, Apollo Group, and Dean Foods, have actually fallen since March.

The steepest discounts remain in what Robert Arnott, chairman of Research Affiliates in Newport Beach, Calif., calls the "loathed and unloved" sectors, including financial and consumer discretionary stocks. Active managers moving into these stocks are "buying greater long-term earnings potential," he says, because survivors will have less competition, and more pricing power and profits as a result.

Outside of the S&P 500, alluring discounts also may be found among small- and mid-cap companies, where market prices don't necessarily reflect a company's fundamentals as well as they do with better-known companies, says William Droms, finance professor at Georgetown University's McDonough School of Business. Here, active managers are often able to add more value than their large-cap peers. That's because information about small companies is less readily available, so original research pays off. The same goes for international and emerging-market stocks, says Droms.

George Feiger, CEO of Contango Capital Advisors in Berkeley, Calif., believes the real plus of active management now lies in being able to avoid countries—and companies—still mired in debt. "As the economy recovers, those with low debt will grow, while the others will still be struggling," explains Feiger. (He favors China, Taiwan, and Singapore over debt-ridden countries in Eastern Europe and South America.)

A HARD SELLBut even though actively managed domestic equity funds have outperformed their benchmark indexes by about two percentage points on average so far this year, the fact remains that active investing largely failed to protect shareholders on the downside last year. In 2008, actives fell by an average of 40%, vs. a 37% loss for the S&P 500. A report written by Francis Kinniry Jr., a principal in Vanguard's Investment Strategy Group, found that over long periods, active funds trail index funds on account of their higher expenses. Research shows that "the No. 1 predictor of future outperformance is cost," he says. The average expense ratio of an actively managed equity fund in Morningstar's (MORN) database is 1.13; among Morningstar's universe of top-ranked funds, it's 1.09.

Vanguard is known for its low costs, but it isn't betting against active funds. "We believe and are committed to both [index and actively managed funds]," says Kinniry. Still, 55% of assets under management (excluding money market funds) are in index funds, up from 47% five years ago.

Vanguard founder Jack Bogle, passive investing's most ardent fan, is "more convinced than ever that indexing works." He has perhaps the best advice on how to choose an active fund: "Look for a management company that is in the business of managing money and not making money." He suggests examining a fund shop's "stewardship." Morningstar assigns letter grades to each fund as a measure of how responsibly the parent firm treats investors. The rating is scored across five categories: regulatory issues, manager incentives, board quality, corporate culture, and fees.

Whether you go the active or passive route, Bogle reminds investors that, above all, the concept of buy and hold is most important. "When we lose, we get out [of the market]. And when we win, we get in," he says, meaning that investors tend to sell low and buy high. "We are our own worst enemy."

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