First - Tidefan, kevindow, Katmanndu, kerryvan - thank you for your honest feedback on the issues at the crux of active mutual fund investing. And BestReturns - I take your point about active mutual fund investing requiring strategies which at extremes can look like momentum-chasing or value-chasing plays (but I didn't appreciate some of the advertising comments).
Katmanndu had some great challenges and asked some really good questions but also mis-understood a couple aspects of my original post. Let me clarify those.
[Katmanndu] An actively managed fund won't actually boost the return of your index fund. It will outperform it or underperfrom it after expenses, but it will of course have no impact on the index fund, as it has no impact on the underlying index...
Let me give an example to clarify what I meant. Take an asset class. Let's say foreign large cap blend. The index is EAFE and for that I hold iShares EAFE (symbol EFA) index fund which I've held since 2002. But within the same asset class, I also have an active fund Julius Baer International Equity (BJBIX), which I've also held since 2002. I currently own 73% BJBIX and 27% EFA which has grown out of balance from the 70%/30% point I was at a year ago. So I will rebalance within the foreign large asset class back to 70% active / 30% index as part of my rebalance. Every year since I've held both (2002-now), BJBIX has beat the index (EFA) by an average of 4.84%
http://quicktake.morningstar.com/FundNet/TotalReturns.aspx?Country=USA&Symbol=BJBIX
which minus 1.19% mgmt fees and minus 1.37% (5-yr) tax cost ratio, still leaves me about 2.28% per year (4.84% - 1.19% - 1.37% = 2.28%) ahead of where I'd be if I was holding 100% index (EFA) and 0% active (BJBIX). So a couple points I want to make with this real-world example. It is possible to "boost" (i.e. end up with larger actual percentage gain) by holding not just 100% index fund within an asset class but by holding an index fund "anchor" and and active fund "booster" which is comprised solely of holdings within the asset class (else we wouldn't be comparing apples-to-apples nor maintaining balance across asset classes). And I agree with your comment, Katmanndu, that the fact that I'm holding BJBIX as part of my foreign large cap holdings has zero bearing on the annual performance of the EAFE index itself. That's not what I was trying to say. I know they're 99.9999% independent. However, by holding a blend of both index plus active I was able to "boost" overall return within my foreign large cap asset class holdings which is what I was trying to do.
[Katmanndu] Seriously, if your strategy really worked, then would you be here asking us for advice? (and) if you are confident that an actively managed mutual fund can beat its respective index, why would you bother owning an index fund in the first place?
Both are good questions. I suppose if every active/index asset class pairing I've got played out like BJBIX/EFA holding above, I may not be asking any questions. :-) So let me illustrate with a counter-example. In 2002, I bought 40% domestic small cap index (Russell 2000, symbol IWM) and 60% active mutual fund Bjurmann-Barry Microcap (BMCFX) with which I was trying to "boost" my domestic small cap overall return. I sold the BMCFX in 2007 and it still sits in cash going into this year's rebalance. If you look at my overall performance within domestic small cap asset class, at first things look promising. If you average total returns vs small cap index for years 2002-2007 (+/- Category for years 2002-2007 at http://quicktake.morningstar.com/FundNet/TotalReturns.aspx?Country=USA&Symbol=BMCFX) you get annual total return of BMCFX about 2.02% above the small cap index. Sounds good. However, when you consider BMCFX 1.58%/year mgmt expenses and 2.43%/year (5-yr) annual tax cost ratio, then my actual return compared to index is 2.02% - 1.58% - 2.43% = -1.99% per year compared to index. (Actually I've painted this worse than reality in that even the index fund has a small expense fee and small tax cost ratio, but it illustrates the point.) So in this asset class category, I'd have been better off (by about 2%/year give or take) just owning the index. (Note - unfortunately my 401K choices are not great and I couldn't buy either BJBIX or BMCFX in my tax-free acount...if I had been able to, both scenarios would look better for active portion and in BMCFX case I'd actually have been ahead of index in the end. I've rolled my 401K to IRA which now gives me more chances to improve on tax-costlier active fund holdings in the future and that'd make both scenarios above, even the "bad example" BMCFX, look better.)
Overall, across my entire portfolio, across all asset classes, if you repeat all of the math above, I'm about 0.5% per year ahead where I'd be holding pure indices in each asset class. I spend about a week solid each year rebalancing and replacing/re-selecting active funds. So if you look at cost of my time vs return, given portfolio size, for me personally, it's been well worth it.
As far as the question "if I'm confident an active fund can always beat index why not just own 100% active?", the answer is "I'm not". Everything centers on probabilities. I'm willing to put a portion of my portfolio at stake based on risk/return that I can beat the index where that portion varies by asset class based on active mutual funds historical abilities to beat the index within a particular asset class. In the examples above, the ratio is 70/30 active/passive for foreign and 60/40 active/passive for domestic mid-/small-cap but for domestic large cap I use 20/80 active/passive because few active mutual funds consistently beat the S&P 500 (because it's such a small universe to pick from to distinguish, I believe). So the active/passive ratio is based on a per asset class risk/return point I'm comfortable with. As a side note, Charles Schwab published suggested active/index mixes based on computed probabilities around year 2000 and I've modified them slightly based on personal observations but would love for someone on the forum to post a pointer to updated active/index ratio holdings per asset class (based on true statistical analysis) if anyone knows of such a thing. I'm sure the statistical ratios shift over time.
At the end of the day, my mechanisms for reviewing and swapping out under-performing active mutual funds doesn't always work as well as I think it needs to demonstrated by the BMCFX/IWM example above. So I'm looking to improve how I make the "sell" determination on active mutual funds I'm holding. If other more experienced active mutual fund investors have good ideas on when to recognize that an active fund isn't performing well compared to its asset class index and exchange it for another active fund WELL BEFORE it becomes an overall loser (including mgmt and tax costs) to holding pure index within same asset class, that's what I'm dying to hear.
[Katmanndu] Sucessful investing in mutual funds requires a long-term commitment, which means you have to be able to stick with a fund through periods of underperforming its peers or its repsective index. I'm not merely parroting some tired old mantra about investing. My personal experience has been that selling a good actively manged fund after a short period of disappointing results has been a mistake followed by an even longer period of regret after these funds vindicated themselves over the long haul. But, it sounds to me like you will probably need to find this out for yourself.
I fully agree with your observations on required discipline and long-term commitment to a plan. Hopefully, you've gotten a feel that I do have a plan and do everything I can to stick to it. What's missing in my plan is something you also hint at above. You say you've made a mistake where you sold a good active fund after short-term disappointing results only to see it recover and go on to vindicate itself in the long-run. I pointed out the opposite case above where after reading Morningstar analyst opinion and continued 5-star rating, I held BMCFX a year or two too long, I believe. So you say you have a mechanism which led you to sell an underperforming active fund too early. My mechanism, which is basically 2-3 years significantly under index, caused me to hold on too long, I believe. Maybe we combine our approaches to become "just right". ;-) But I'm looking for the right hard-and-fast "sell" approach on an underperforming active mutual fund. I think this is the key to improving my slightly-above-index results to make them more-above-index.
If you're a passive index fund only kind of investor, I suggest you don't weigh in with flame on this thread but let the active investors do their best to call out a real-world mechanism (not gut feel) that enables them to long-term beat indices with active mutual funds. In my own personal experience, the hard part and the heart of a deterministic mechanism for maximizing asset class returns with active mutual funds portion of holdings is in determining the right "sell" point for active funds.
Sorry for the long note. Wanted to make things as clear as possible. Thanks again for all of the thoughtful responses already shared and those to come.
-Andy
