Why You Shouldn't Put All Your Money in Index Funds

Among mutual fund analysts, John Rekenthaler is one of the best. A Morningstar veteran, he writes a regular, must-read column. So I was surprised to read the first sentences of a recent piece: "Do active funds have a future? To cut to the chase: Apparently not much."

Rekenthaler is as dead serious as, in my view, he is dead wrong. Look at his case : Over the 12-month period that ended June 30, 68% of new fund investments have gone into index mutual funds, index exchange-traded funds and other passive strategies (passive means a human is not picking the stocks and bonds). A mere 32% of fresh cash went into actively managed funds -- those run by well-paid managers who decide what to buy and sell.

Don't get me wrong. Index funds have a lot to recommend them. The best ones -- many of which are run by Vanguard -- offer a low-cost way to invest in broad market indexes. I myself have offered index portfolios to readers . Over time, broad stock market index funds have regularly beaten about two-thirds of actively managed stock funds. And it's a lot harder than it looks to identify in advance the one-third of actively managed funds that will beat their index competitors.

In short, I think index funds have a place in virtually every portfolio. But, in my view, few portfolios should consist entirely of index funds.

Why? Because index funds are designed to give you all the upside of bull markets and every bit of the downside of bear markets. Only good actively managed funds can protect you from some of the pain of a bear market.

Today, 5½ years into a roaring bull market, the clamor for index funds belies common sense. Paying 0.5% or 1% of assets annually for active management seems like wasted money to many.

Contributing to the rush into index funds has been the unusually strong performance of Standard & Poor's 500-stock index recently. Over the past 12 months, the S&P 500 returned 22.9%, and Vanguard 500 Index ( symbol VFINX ), one of the largest S&P index funds, gained 22.7%. The fund's one-year return outpaced 73% of mutual funds that focus on large U.S. companies. Moreover, U.S. stocks have beaten most foreign indexes handily of late, and I fear that some naïve investors conflate S&P 500 index funds with all index investing. (All returns in this article are through August 19 unless otherwise noted.)

But consider FPA Crescent ( FPACX ). Steve Romick and his team have delivered an annualized 9.1% return over the past 10 years -- beating the S&P 500 by an average of 0.8 percentage point per year.

The main secret to Romick's success lies in dodging much of the damage of the 2007-09 bear market, when the S&P 500 plunged 55.3%. FPA Crescent lost only 27.9%. Yes, the fund's annual expense ratio of 1.14% is high compared with the fees charged by index funds, but, in this instance, it's worth it. Today, the fund has just a bit more than half of its assets in stocks and most of the rest in cash.

And FPA Crescent is hardly the only conservative stock fund that promises to soften the pain of the next bear market. Matthews Asian Growth & Income ( MACSX ), which lost 39.4% in the 2007-09 bear market, and Vanguard Dividend Growth ( VDIGX ), which lost 42.3%, are two more fine examples.

Among broker-sold funds, Rekenthaler himself points out that every American fund with at least a 15-year record has beaten its relevant index over that time.

Part of the enthusiasm for passive strategies is aimed at esoteric and often expensive ETFs that invest according to "rules-based" formulas. Take Guggenheim Insider Sentiment ETF ( NFO ). It invests in 100 stocks whose shares have been heavily bought by corporate insiders. Such insiders have been shown in numerous studies to be savvy investors in their companies' shares. The ETF charges 0.65% annually. But I'd rather pay a bit more to have a smart manager consider not just the level of insider buying but other criteria as well.

As for the broad-based index funds, they make sense a lot of the time for a lot of investors. But the wholesale rejection of actively managed funds makes no sense at all -- and will cost investors dearly during the next bear market.

Steven T. Goldberg is an investment adviser in the Washington, D.C. area.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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