Choosing Between Active Mutual Funds and Passive (Index) Funds

By Russell Wild

One of the hottest debates among investors — one that will never end — is whether actively managed investments are any wiser than index fund investments. The simple answer is usually no, they are not. The vast majority of index investors do better than the vast majority of active investors. Although various studies show various results, none contradicts the basic premise that indexing works, and works very well.

When you look at bond funds in particular, however, things get a bit muddled. On one hand, bond index funds are way cheaper than actively managed bond funds, just as stock index funds are cheaper than actively managed stock funds. But because bond funds tend to yield more modest returns, costs are more important. A fund made up of bonds that collectively yield 5 percent that costs 1 percent to hold suddenly yields 4 percent; that’s a difference in your return of one-fifth.

But there’s another side to the story, explains Matthew Gelfand, PhD, CFA, CFP, managing director and senior economist with Rockefeller Financial. Despite the cost/yield equation, which Gelfand doesn’t deny for a second is very important, he argues that active management of bonds can make sense — in fact, it makes very good sense, because bonds are so much more complicated than stocks.

“There are many, many more bonds and kinds of bonds than there are stocks on the market,” says Gelfand. “The analyst coverage is much more sparse. Although more and more trading now is through electronic markets via the web, trading is still mostly over-the-counter, so bid/ask spreads remain wider than in stock markets. All this makes for a less ‘efficient’ market and allows for good active managers to add real value,” he says. “If you can find a reasonably priced, well-managed active bond fund, it stands a better chance of outperforming a bond index fund.”

There’s certainly nothing wrong with passively managed (index) bond mutual funds or exchange-traded funds. They can, and often do, make excellent investments. Still, handpicking the right actively managed bond fund, if you do so smartly, can juice the returns of your fixed-income portfolio, with limited additional risk.