A sea change has been reshaping portfolios in recent years. Investors have been fleeing actively managed funds and flocking to index funds.
Investors have, on net, withdrawn money from actively managed U.S. stock funds and invested in U.S. stock index funds every year since 2007. They may have been chasing performance. Not a single category of actively managed funds has managed to beat comparable index funds over the past 10 years through June 2017, according to Morningstar.
But the tide could be turning. In the 12 months through June, eight out of the 12 actively managed fund categories that Morningstar tracks beat peer index funds.
Stock correlations — the degree to which individual stocks tend to move together — have been plummeting since 2016. That makes for a fertile environment for stock pickers, who can more easily beat an index when fewer stocks and sectors move in lockstep with it.
Of course, index investors might not fret about missing out on a slight performance advantage. But they might feel differently if they knew that they could be staring down larger losses than their active-fund counterparts during the next bear market.
Active funds may shine in down markets in part because managers can keep more cash on hand than do index funds. But it’s also likely, if difficult to prove, that active managers might identify excesses and trim troublesome sectors before stocks turn south.
This is not to say that investors should avoid index funds. They offer valuable benefits, chiefly lower costs and instant diversification.
Index funds that invest in large U.S. companies have a winning long-term track record. But with $2.2 trillion of passive assets pegged to the S&P 500, investors wary of market distortions should consider broader-based choices, such as Vanguard Total Stock Market (VTSMX) or its exchange-traded cousin (VTI), which is a member of the Kiplinger ETF 20, a list of recommended exchange-traded funds. Fidelity Total Market (FSTMX) is another good choice.
These funds are market-capitalization weighted, meaning investors bear the risk of loading up on the priciest stocks in a soaring market.
Consider offsetting them with a proven value-oriented fund, such as Dodge & Cox Stock (DODGX). The fund is a member of the Kiplinger 25, a list of favorite actively managed no-load funds.
Equally weighted index funds, in which each holding accounts for the same portion of the fund, may also better avoid bubbles. They may have higher costs and greater turnover. One targeted fund that is a good buy is Guggenheim S&P 500 Equal Weight Health Care (RYH), an ETF 20 member.
To add more exposure to midsize and small companies, consider adding one or more active funds, such as Kip 25 member T. Rowe Price Small-Cap Value (PRSVX).
Elizabeth Leary is a contributing editor to Kiplinger's Personal Finance magazine. Send your questions and comments to firstname.lastname@example.org.