I would characterize my personal portfolio as 85% passive, 15% active, and 100% low-cost. Why is part of my portfolio managed by people trying to generate “alpha”? Aren’t I supposed to say that index funds are always better? Author and money manager Rick Ferri has a good post about When Active Funds Makes Sense, even he is a well-known index fund advocate.
Here are a few circumstances when I consider an actively managed fund over an index-tracking product:
- The absence of a diversified low-cost index fund or ETF that tracks the asset class.
- An active fund is lower in cost than an equally diversified index fund.
- An active fund has greater diversification than an index product, even if the fee is slightly more.
- The unique risk I am trying to capture is better suited to active management than in an index-tracking product.
He then discusses in detail a few categories that satisfy these conditions: municipal bonds, high-yield corporate bonds, and value stock strategies. I was particularly interested in the muni bonds part:
Municipal bonds: The tax-exempt municipal bond market is fragmented, localized and often has liquidity concerns. This creates an environment where the rigidness of tracking an index may be more of a burden than a benefit. There are some low-cost municipal bond ETFs that have enough volume to work around the issues of this market; however, a broadly diversified and low-cost actively managed municipal bond fund that doesn’t need to track an index is often a better alternative.
The largest muni bond ETF that passively tracks an index is the iShares National AMT-Free Muni Bond ETF (ticker MUB) with a 0.25% expense ratio, 7.25 year effective duration, 2,000+ holdings, and over $3 billion in assets. But I actually invest in Vanguard’s tax-exempt funds, which are actively-managed and don’t track any specific index. For example, the Vanguard Intermediate-Term Tax-Exempt Fund is cheaper (0.12-0.20%), more diversified (3,000+ holdings), and is 10 times larger (over $30 billion in assets).
As usual, Tadas Viskanta at Abnormal Returns does a nice roundup of various voices on active investing while adding his own take:
The financial media not one for subtlety. The indexing=good, active=bad meme is the dominant one at present. There are some very good reasons why investors may want to try to take advantage of actively managed funds in select sectors. Provided you have the right framework and expectations this can make perfect sense. However as noted above investors should keep a keen eye on costs and recognize that we are talking about the slices of the portfolio pie, not the whole pie.
It certainly does feel that index funds have a lot of momentum right now. Even the hugely-popular American Funds are experiencing huge outflows. I think it is better to remember that low-cost vs. high-cost is more important than passive vs. active. Another key takeaway here is that buying a popular index ETF to replicate every asset class isn’t always the best option.