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Oct. 28, 2016, 11:20 a.m. EDT

This might be the time to turn away from index funds

Active fund management can outperform when the stock market stalls

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By Philip van Doorn, MarketWatch

Justin Sullivan/Getty Images
Citigroup is the largest holding of the $5.1 billion value portfolio run by Brandywine Global Investment Management.

Patrick Kaser, a fund manager at Brandywine Global Investment Management, punched holes in two of the biggest arguments in favor of index funds over actively managed funds.

And he showed how a value-oriented manager can make investments in out-of-favor stocks that have the potential for big gains. That strategy works well in bear markets or down periods for equities. Index funds can’t follow that strategy.

The two arguments Kaser tried to refute are that index funds have much lower expenses than actively managed funds. True, but the institutional share classes of actively managed funds, offered in retirement plans, often have much lower expenses than other share classes. He also said active managers will gain an advantage as more money is passively managed.

Kaser and his team are running “toward the fire in many ways” with Brandywine’s $5.1 billion so-called classic large-cap value equity portfolio, managed for private clients. One way is by favoring shares of large banks, which are trading at low multiples to earnings. Another is by holding shares of U.S. car companies, which he believes are likely to outperform very low expectations.

Brandywine Global Investment Management is based in Philadelphia and manages about $70 billion in client accounts.

“If the world were 90% passive and 10% active [fund management], the active investors would do very well, because they would be able to react to events.”

Patrick Kaser, portfolio manager at Brandywine Global Investment Management

Before looking further into Kaser’s strategy, let’s discuss the argument over passive vs. active investing, which we have been covering over the past week.

Should you follow the herd?

Large groups of investors tend to move in the same direction, and it’s more than clear that the herd is running toward passive management (index funds). As with any trend, things may backfire for those who bring up the rear when following the crowd. It’s also worth considering that the expense advantage of index funds may not be so great if the bulk of your investments are made through a 401(k) or other employer-sponsored retirement plan.

Expenses and share classes

Many excellent arguments in favor of index investing over active investing have been made. One has been the lower management fees you pay in an index fund, which is, for the most part, run by computers. But this advantage may not be as great as you think.

According to Morningstar, the average total annual expense ratio for actively managed mutual funds is 1.20% of assets versus 0.83% for index funds.

“Let’s concede first that retail funds are dramatically overpriced. If you are paying 100 to 130 basis points for a retail fund, John Bogle is absolutely right. You’re absolutely eating into your return,” Kaser said.

Bogle is the founder of Vanguard Group, which dominates index-fund investing. A Morningstar list of the largest U.S. mutual funds has four of the company’s index funds at the top, with combined assets of over $1 trillion.

Brandywine Global Investment Management
Patrick Kaser, portfolio manager for Brandywine Global Investment Management

But Kaser pointed out that many of the larger actively managed funds have institutional share classes with considerably lower fees. These are probably available to you, if you participate in a 401(k) or other employer-sponsored retirement plan. It’s worth looking into the annual expense ratios of your mutual funds, and you can do this easily by calling your plan provider.

“A lot of institutional investors are not paying that much for active management. They are paying maybe 30 to 60 basis points” a year, Kaser said. You might be paying relatively little for active management in your retirement plan, and it might be worth it over the very long term.

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