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Home » Active vs. Index Funds: Which Are Better in a Downturn?

Active vs. Index Funds: Which Are Better in a Downturn?

by Ryan Hughes
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As global markets head toward the finish line of what’s been an extremely volatile year, financial advisors and planners, as well as individual investors, are reviewing their strategies. Does it make sense to use index funds in a challenging environment, or adapt with actively managed funds?

While most financial advisors today use asset allocation in any market environment rather than picking stocks, not all funds are the same. Traditionally, exchange-traded funds, or ETFs, tracked an index, such as the S&P 500 or the Bloomberg Barclays Aggregate Bond Index. However, that’s not always the case nowadays, as a growing number of actively managed ETFs have come to market.

On the flip side, mutual funds are generally associated with active management, a system wherein a team of managers researches, analyzes and chooses stocks. However, there are some mutual funds that track indexes as well, so owning a mutual fund doesn’t necessarily mean you have an active investment.

A growing number of advisors have gravitated toward index investing in the past decade. But in a market downturn, is there any merit in turning to actively managed funds?

Actively Managed vs. Index Funds

“There is a place for both active and passive funds in a portfolio; the key is to use them both thoughtfully and to the best effect, maximizing their strengths,” says Bryan Shipley, chief investment officer at Arnerich Massena in Portland, Oregon.

Shipley points out something that advisors routinely counsel clients about: It’s difficult to consistently outperform the broader market in a highly efficient asset class, such as large-cap U.S. equities. Here, he notes, index funds typically provide broad exposure to the opportunities in that category, and at a lower cost than actively managed funds.

Generally, active funds have higher expense ratios than index funds, in large part because of the costs inherent in operating a team of analysts and managers. Those are costs that index funds don’t incur.

But when investing in certain other asset classes or niche areas of the market, there may be a role for active management, Shipley says.

In those cases, there may be a wider spectrum of potential investments, which allows more latitude to differentiate from the overall market.

“In asset classes like U.S. small-cap or emerging markets, for example, active management has a greater potential for outperformance,” he says.

In a market downturn, Shipley adds, “The greatest advantage of actively managed funds is that they are able to make defensive moves to counter the market challenges.”

Index funds, meanwhile, are specifically designed to simply deliver market returns, whereas active funds may be able to mitigate some of the risks, he points out.

Actively Managed Funds in a Market Downturn

Ryan Redfern, president and chief investment officer at Shadowridge Asset Management in Austin, Texas, says investors should evaluate all their options in a market downturn, including holding cash.

However, if the choice comes down to holding active or index funds, he would opt for an actively managed fund whose manager has the flexibility to hold a lower percentage of equities. He says if a fund is required to be fully invested at all times, then the active vs. passive consideration becomes irrelevant.

“Personally I like to mix both active and passive depending on the market environment,” Redfern says. “If I can have a few funds in the portfolio that can be more drastic or have a go-anywhere philosophy, then I have a better chance of surviving a downturn.”

He adds that he tailors his investment approach to market conditions, saying there are times to be all-in, and times to take a more tailored stance. To successfully implement that kind of flexibility, an advisor must keep track of market conditions, not just run a set-and-forget portfolio.

“For example, to survive 2022 so far, it has been beneficial to lean toward or be all-in on the value side, and avoid growth altogether,” Redfern says. That’s a big shift for investors, as growth was the leading equity asset class for several years prior.

Flexibility Is Key in Choosing Active or Index Funds

“The benefits of being willing to adjust your strategy can help you avoid the losses of a major market correction and set you up to catch more of the rebound,” Redfern says.

There’s a practical reason for advisors to avail themselves of actively managed funds when warranted, says Misty Garza, vice president and financial advisor at Bogart Wealth in Houston. “As a professional money manager, you should tailor your approach to market conditions,” she says. “This is what clients pay us for; otherwise they could do it themselves. Most clients want to limit their downside volatility while capturing as much of the upside.”

Garza adds that this requires a flexible investment approach.

“There can be a place for both during certain market times,” she says. “Actively managed funds do not comprise every aspect of the market, and sometimes we will use passive index funds to capture a particular segment of the market we feel will outperform and that we cannot find anywhere else in the active space.”

Source : USNews

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