By ANNA PRIOR
Does it pay to stay active?
Actively managed stock mutual funds rebounded in 2009, ending slightly ahead of their no-frills, passive counterparts: index funds. But it was barely enough to make up for their dismal showing the previous year.
So, the perennial active vs. index debate rages on in 2010.
Active U.S. stock funds were up an average 32.8% last year over all, compared with index funds' 31.7%, according to investment-research firm Morningstar. Yet during the market's brisk rebound from its March 9 lows, index funds took the lead, surging 82% as active funds jumped 73%.
Over the course of last year, 48% of active funds outperformed their corresponding Russell index, up from 43% in 2008.
Brian Hogan, president of the equity group at Fidelity Investments, says, "We're in a great stock-picking environment right now. And this bodes well for active management," which is able to identify inefficiencies in the market and exploit them through research, trading and portfolio construction.
But Scott Burns, director of ETF research for Morningstar, says the decision to buy an index fund isn't "saying that you can't beat the market. It's just saying you don't know who will beat the market and that you'd rather keep costs low and have the average rather than risk picking a stud or a dud."
If you're choosing between actively managed and index funds, here are five things to keep in mind -- things an active fund manager may not tell you:
1 A Good Run Will Not Last Forever.
"Top-tier active managers with long-term benchmark outperformance almost inevitably have periods of three years or more where they underperform," says Bill Thatcher, a senior consultant at research and consulting firm Hammond Associates in St. Louis.
Some of the winners over the past decade lost big in late 2008 and early 2009.
After beating the Standard & Poor's 500-stock index for 15 years, Bill Miller, manager of the Legg Mason Capital Management Value fund, was down 55% for 2008, while the S&P 500 fell 37%. The fund ended 2009 up 41%, but lost more than 67% from the market peak in October 2007 through February 2009.
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A $10,000 investment 15 years ago would be worth about $36,173 today. But anyone who jumped in with $10,000 around the peak of the market in October 2007 would have just $5,734.
"Yesterday's winners are far more likely to be tomorrow's losers," says John Bogle, founder of mutual-fund giant Vanguard Group and a champion of low-cost index funds.
Michael Mauboussin, chief investment strategist for Legg Mason Capital Management, says, "When you see streaks in investing, it's luck and skill combined." Bad luck played a role in the fund's 2008 performance, he says, just as skill played a role in its rebound last year.
2 Expense Ratios Vary Widely.
Both types of funds have an expense ratio -- reflecting fees to pay for everything from administrative costs to the portfolio manager. It's expressed as an annual percentage of fund assets, and can range from under 0.1% for an open-end index fund to more than 2% for some actively managed funds.
On the whole, the expense ratios for actively managed funds are significantly higher than for index funds, with the average being 1.4% for the former and 0.9% for the latter, according to Morningstar.
3 Other Fees Can Add Up.
Then there are transaction and trading costs. These are more likely to be higher for an actively managed fund, which typically does more trading than an index fund. They average about 1.4% or 1.6% on top of the published expense ratio, says Dan Culloton, associate director of fund analysis at Morningstar.
In addition, some funds charge a commission, called a "load," either when you initially invest in the fund or when you cash out your investment.
"Actively managed funds' costs are higher than index funds' costs," says Mr. Thatcher. But "on the whole, active funds' higher costs do not buy you better performance."
4 Short-Term Gains Can Be Taxing.
Actively managed funds trade more frequently, so many of the gains tend to be short term, says Stephen Horan, head of professional education content and private wealth at CFA Institute, a nonprofit association of investment professionals. And short-term gains are taxed as ordinary income, with rates as high as 35%.
Index funds, on the other hand, tend to buy and sell less frequently. So more of their gains are long term, and, thus, subject to the lower capital-gains rate, a maximum 15%, Mr. Horan says.
The activities of other investors also can impact your returns and tax situation, says Morningstar's Mr. Burns. If people start heading for the door, as they did in 2008 and early 2009, a fund manager is more likely to sell winners, instead of losers, which could increase short-term capital gains.
5 If It Acts Like an Indexer...
Watch out for closet indexers -- actively managed funds that mimic an index -- especially if they are charging high fees.
If a fund is never too far ahead or behind its benchmark index and its correlation is really high with that index, that could be a sign of a closet indexer, says Mr. Culloton. Also, does a fund have hundreds of stocks in rather small positions or do its holdings look the same as the index but slightly rearranged, he asks.
"If you find a fund that's got all of these traits and it's charging one percent or more," Mr. Culloton says, "you have to ask yourself why."
Write to Anna Prior at anna.prior@wsj.com