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Active or Passive Management-or Both?

We often see the debate in the financial press between those who tout the benefits of low-cost index investing versus those who favor actively managed mutual funds. Those who endorse a passive indexing approach often criticize the generally poor long-term results of active mutual fund managers. Those who favor active management usually tout their better performance, usually over a selected time horizon that favors their performance track record.

We agree that there are times when low-cost, tax-efficient index investing makes sense. Some asset classes do not have any funds or managers that have a clear, consistent track record of beating the category average or benchmark index over the long-term. All things being equal, low expenses and tax-efficiency make a good default option, and we are always seeking to lower expenses and minimize taxes.

We also agree that most funds do not beat their benchmark or deliver average returns. Numerous studies have shown that most mutual funds do not outperform their asset class or market averages over the long-term. A recent Morningstar study showed that only 37% of active funds beat their index after adjusting for their risk levels.

However, we also believe that investors should not give up on active management and just buy index funds. As in any endeavor, skilled investors are still able to add value over long-term time horizons. We are not looking for the 63% of the mutual fund managers that do not beat the market, we are looking for the top 37% that do!

Those who argue against active management citing the fact the 70% or 80% of active managers do not outperform their index or the overall market are missing a few points. The same Morningstar study shows that fund managers who rank in the top quartile tend to outperform on a consistent basis, beating their benchmark index by 3.00-4.50% over 3-year periods. This is consistent with our the performance of our “All-Star” managers that we incorporate in your portfolios. The average batting average in the American League is .267-would you rather have an average catcher or Joe Mauer, who hits .365? He still fails over 60% of the time, but those extra hits add up over time and really make the difference.

Expect us to incorporate more active managers in our investment lineup during the months ahead. A recent study by American Funds showed that active funds tend to outperform strongest in the 5-year period following extreme market declines. If we experience the “New Normal” with a slow growing economy and lower market returns, that extra 3-4% of “All Star” returns will help tremendously!

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