How We Use Actively Managed Funds in Our Portfolios

How We Use Actively Managed Funds in Our Portfolios

Part of our core investment philosophy is optimizing the risk/reward relationship within our portfolios. In the context of portfolio design, the risk/reward relationship we are referring to is that for each fund category, relative to its benchmark index.

Broadly speaking, index funds follow rules-based management and are meant to replicate the volatility and performance of their respective index, with very little variation, and low expenses. As such, we use index funds as the baseline when evaluating other funds in that category.

On the other hand, actively managed funds have more discretion in what the fund is investing in, as long as those investments align with the objectives and constraints outlined in the prospectus (e.g. a US Equity Fund might be allowed to invest up to 25% in non-US companies, but not more than that). Because of the additional resources needed to facilitate the research and trading, actively managed funds generally have higher expenses than index funds and can range from under 0.5%, to over 3%.

When an actively managed fund is invested too similar to its benchmark index, it will generally underperform due to the drag of the higher expenses on returns, which is why index funds generally outperform the vast majority of mutual funds.

This means that active funds need to invest differently than the index which, regardless of the results, makes them relatively riskier than a comparable index fund. As such, actively managed funds need to generate materially higher returns to compensate for that additional risk.

When building and adjusting our portfolios, we start will all index funds and then research potential actively managed alternatives for each. The key attributes that we look for are:

  • the fund’s investment philosophy and process,
  • the manager’s frequency (and degree) of outperforming the index over 3-5 year periods,
  • the amount of the manager’s personal money invested in the fund,
  • fund expenses,
  • manager and team tenure, and
  • the type and number of companies they are investing in.

We generally measure this over 1, 3, and 5-year time horizons and give different weightings to each metric and lookback period. We also use have some knockout criteria that will eliminate certain funds out of the gate. If there’s no clear and compelling winner(s), we stick with the low-cost index fund. If there are multiple funds that we like, we dive into more granular analysis and comparisons between them and keep the runner-up on our radar for tax-loss harvesting purposes and future consideration.

Our experience has generally found that good, actively managed funds are more common for bond funds, international equities, and for small/mid-cap US equity funds. We’ve also found that these funds also have tenured teams with a material amount of personal money invested in the funds they manage, below-average expense ratios, limit the number of companies they are investing to 15-30% of those in the index, and are investing in companies based on a 3-5 year outlook.

The resulting portfolio is what we refer to as a “core & satellite” approach. The index funds are used for the core, keeping expenses low and deviations in returns (from the benchmark) at a minimum. The actively managed funds serve as the satellites for the remainder of the portfolio, letting those managers do what they do best. While some advisors choose to pick individual stocks for the satellite portion, we choose to use highly concentrated funds instead, leveraging the breadth and depth of those portfolio managers and their teams.

While there are many different ways to build and manage a portfolio, this is the approach we’ve found to be most successful and durable over the long term, and in a manner that aligns with core beliefs and philosophies.

If you have any questions or would like to explore whether Traverse Planning is a good fit for your planning and investment needs, feel free to send us a message, give us a call at (303) 957-0307, or schedule a no-obligation intro call to learn more.