Investors have gotten used to pouring money into index funds and seeing their returns swell. But are they still the best bets for retirement?
The turning of the tide with rising interest rates, inflation and geopolitical instability is challenging index funds. Investors must wonder if index funds will remain the best mutual funds and ETFs. And how do active strategies, if any, fit into a retirement portfolio?
Index Funds Tough To Beat For Retirement
It is a well-known fact that fund managers on average have a hard time beating the market indexes over time.
S&P Dow Jones Indices' recent biannual SPIVA (S&P Indices vs. Active) US Scorecard for 2021, found that last year was the third-worst year on record for active managers.
While absolute returns were positive for both active and passive equity funds, 80% of domestic equity funds and 85% of active large-cap funds trailed the S&P 500. Mid- and small-cap funds fared even worse. Meanwhile, positive net assets flowed into passive funds while active funds experienced net outflows.
That said, some areas of the market traditionally lean toward more active management. According to Morningstar Direct, active funds in the areas of alternative and nontraditional equities showed net inflows at the end of March. So did intermediate core bonds and bank loans.
Comparing Active And Index Funds For Retirement
So, how do retirees or those preparing for retirement need to think about active vs. passive index funds?
"Active investing gets a bad rap in that the comparisons are usually made by people who are advocates of passive investing and don't really think about the realities of the investor situation," said Jerry Wagner, founder and president of Flexible Plan Investments. "And retirement is one where active investing is really essential."
He noted that "basically we're all active investors. Because everybody buys and sells. It's rare that anybody just buys something and puts it in a safe-deposit box or a certificate, and never changes it. So, we all become active investors at some point. The question is how active, and whether it's a disciplined, quantitative process?"
Find A Place For Active In Retirement?
In Wagner's view, active investing should always be a part of someone's portfolio, because it's very difficult to predict when the switch should be made. And for retirees specifically, risk management and limiting losses is essential to reaching one's goal.
"If you take a hit early in your retirement, the amount of money you then have to live on is severely reduced," he said. "If you add a risk-management component, however, where you're limiting losses in the portfolio, you have the chance to be reactive to the market and to do what the market is suggesting, and so you can reduce your overall losses."
Go Beyond Index Funds For Big Downturns
Wagner says that diversification alone is not enough. It helps in periods of short and shallow market downturns, what Wagner calls "baby bears" — corrections of zero to 20%. "A diversified portfolio that most retirees have can handle that. The problem is when you have the 'grizzly bear' — the bear that comes on in the 30% to 70% downturn."
These downturns tend to be longer and have all asset classes correlated to each other. "So diversification is no longer a protection in a grizzly bear market. And it's the grizzly bear that we build the risk management for, that active management for."
Because if the grizzly bear hits early in retirement, he stressed, "That's when it punishes you, early on." So, it's very important to try and preserve capital in retirement.
Active And Index Funds Work Together?
When looking at the current environment, Rob Young, senior investment strategy specialist at Calamos Wealth Management, agrees that it's a great time to discuss active and passive strategies.
"The decision of active vs. passive isn't mutually exclusive. We incorporate both when constructing portfolios for clients," he pointed out. "Passive has the advantage from the cost perspective and getting the exposure to the market. Where active really thrives, is it can provide that complement, or getting greater exposure to specific areas of the market that you might want to have that exposure to."
In addition, active can provide a greater risk-adjusted return in uncertain markets, "where we're in right now," he said. "Our overall message to clients is not strictly just returns. Our overall message is complemented by risk as well, and that's where active really gets incorporated. We're looking for the best risk-adjusted return."
Investors Still Prefer Index Funds For New Money
With the S&P 500 down over 10% this year and the tech-heavy Nasdaq composite off 18%, some of the best mutual funds and ETFs are treading on thin ice. But despite seeing overall weak flows, index funds still amassed $15.3 billion in assets in the first quarter, while active funds lost $6 billion.
Weakness in the market likely spurred some investors to pour money into some index funds, noted a Morningstar Direct report. And as markets declined, areas like alternative investments served as portfolio diversifiers. Alternative funds' assets grew 9.3% in the third quarter. That's the third-highest of any category group and their highest growth since 2011, reports Morningstar.
Getting Active With Index Funds
According to Rob Williams, managing director of financial planning, retirement income and wealth management at the Schwab Center for Financial Research, investors can also use indexed strategies in tactical or active ways. "Passive doesn't mean inactive," he said.
Investors can maintain a core indexed strategy, he said, but they can choose between a market-cap weighted or a more fundamental indexed strategy. The fundamental, or the more defensive, area is where he sees more value. Investors can then still add other layers to their portfolios with market-weighted or active funds. Active funds usually cover less liquid areas of the market such as fixed income or emerging markets.
Keep An Eye On Fees
Williams said the key is to maintain a disciplined long-term investing approach. And that takes into consideration fees and taxes.
"People have been calling for the active vs. passive investment style for a long time, and it hasn't necessarily worked out," said Megan Horneman, chief investment officer of Verdence Capital Advisors.
"But I think there are some things that have really changed over the past year that we haven't seen in decades. And (among them) is rising interest rates to combat inflation. So, that easy monetary policy that we've seen for decades is really coming to an end," she said.
This will result in companies finally being really rewarded for good fundamentals and not just on momentum, she added. "Being active and being able to find those companies that do have that fundamental basis is going to be very important."
She believes that active investing now should include not just active asset allocation, but also active product-level selection, such as active mutual funds or active ETFs.
