Take the 'bull' by the horns

As markets return to normal, investors who lessen reliance on index funds likely to get better returns

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Index funds and other passive funds that invest in the broad stock market averages tend to outperform actively managed funds when markets are headed in one general direction or another. During the financial crisis of 2008, the price of almost every major asset was headed down.

With that storm behind us, markets have come back to normal, and some financial advisers say the tide has turned.

Robert Fragasso, chairman and CEO of Fragasso Financial Advisors, Downtown, said index funds are best used as a component of an investment strategy. Those who use them solely as an investment philosophy could be limiting themselves to mediocre returns or even putting themselves at risk of losing money.

"In certain markets, the indexes do well," he said. "You can buy the index and you will simply get the average. The argument is that the majority of managers don't do as well as the index. That's true. The majority of managers don't do as well as the index. But yet a minority of managers do. So we don't take sides. We do both.

"We use the index funds as a balancing point in every sector of a portfolio and then we seek out the active managers who can outperform the index and put them together. So if the active managers are having a hard time, we know that the bulk of what we are doing is still going to get the averages."

These days, investors who pick the wrong index funds could find themselves in a world of hurt.

Although bond index funds have performed well in recent years as interest rates have been falling, those index funds are not likely to deliver the same returns now that rates are on the way back up. The value of existing bonds goes down as rates rise.

"If you bought an index fund and you have a heavy dose of long-term bonds, you are going to get your head handed to you," Mr. Fragasso said. "Yet people don't understand that because of all the advice they are getting, which says they can buy the indexes and everything will be fine.

"Another example of one of the indexes you would have bought following that mantra is 'emerging markets.' That's a stock index," he said. "But if you didn't understand what was going on in emerging markets, you would have sat there mindlessly until your portfolio dropped 20 or 30 percent."

Adam Yofan, president of Alpern Wealth Management, Downtown, invests only in index funds for his clients. He believes pre-retirees or retirees could be better off investing in index funds because finding active managers who can consistently beat the market averages is not easy.

"When you hire an active manager, you are hoping that person or firm has better insight than other people or firms into a company's future prospects and profit," Mr. Yofan said. "However, this insight is gleaned from publicly available information."

Mr. Yofan said active portfolio management is analogous of one roomful of Harvard MBAs looking at Company XYZ's annual report on one end of town, and another roomful of Harvard MBAs at another firm looking at the same information on the other end of town. One firm thinks the stock is a buy. The other thinks it's a sell. Which is right?

"It is very difficult to predict a future stock price unless you can predict the future. The day before the BP Gulf disaster, one firm bought shares for their mutual fund and another sold. The stock dropped after the disaster. Was the selling firm lucky or skillful?

"BP didn't send a memo out saying, 'Tomorrow we are blowing a hole in the Gulf of Mexico. Get out today.' "

Cameron Short, senior vice president of investments at Stifel Nicolaus, Downtown, said he also believes the indexing world is going through a bit of change due to shifting markets.

"Active investing tends to work best when markets and sectors are not highly correlated," he said. "Correlation tends to spike during market crises. Correlation tends to decline as conditions improve.

"When stocks move with less correlation, it creates a larger separation between winners and losers, which may give actively managed portfolios better opportunities. Keep in mind, both active and passive investing may coexist within a well-diversified portfolio."

Another example of how investors could get hurt with indexing is through target-date funds, Mr. Fragasso said.

Many investors who had planned to retire in 2008 were unable to due to heavy losses they sustained when the financial crisis hit hard on portfolios heavily invested in stocks at that time. Now bonds inside target date funds could pose a similar problem.

"I'll tell you what is going to happen to target date funds, especially the ones that are in close proximity to people needing it -- who are either retiring or using it to educate their kids -- they have bonds in there. You know what will happen to those target date funds if interest rates go up? They will be cashing out to pay their kid's tuition at a 10 percent to 20 percent discount from face value," said Mr. Fragasso.

"There absolutely will be trouble on the horizon for people who rely solely on mindless indexing, target-date funds and other 'set it and forget it' passive investments to meet their goals.

"Every investment in the marketplace has its time. When the tide is rising, all boats go up with it. But when the tide is choppy, some boats will go up, but others will go down."


Tim Grant: tgrant@post-gazette.com or 412-263-1591


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