Why You Should Choose Active Management Over Index Funds

Why You Should Choose Active Management Over Index Funds

Since the 2008 financial crisis, increasing numbers of investors have flocked to index funds — mutual funds that are passively managed by computers.

The trend has continued, and today, index funds comprise about 35 percent of total equity fund investments.

But while index funds may seem like a solid investment, they may not actually be the best place to put your money because their popularity is threatening to drive up prices beyond reason. History is rife with examples of systems to “beat the market” that cease to work once widely embraced.

“When everybody invests in the same thing, the prices become distorted because it drives too much money to one area of the market, and eventually it falls apart,” said Anne Chernish, CFP® President & Managing Member of Anchor Capital Management, LLC, in Ithaca. “Everybody can’t do indexing forever and have it work.”

The Indexing Strategy

Passively managed funds attempt to match prominent indexes such as the S&P 500 or the Russell 2000. They rely on computer programs to track the companies that are included in a given index and assign them equivalent values in the tracking index funds they are developing.

As companies shift position within the prominent indexes, the computers recalibrate their value in their own index funds, removing firms that fall to the bottom as new ones rise to the top.

This strategy distorts market prices because it draws money to the mostly highly priced issues and ignores more appropriately priced small- and mid-sized companies.

“In the U.S. and Canada combined, there are 22,000 companies, but if people are only looking at the 500 to 2,000 most highly priced companies, they are only looking at 3 to 10 percent of the available issues,” Chernish said. “If everybody is only pouring their money into the top 3 to 10 percent of the market, those few issues will get too expensive.”

The Difference with Active Management

One alternative to parking your money in index funds is investing with a professional manager who can diversify your portfolio among a broad range of companies, including small- and mid-sized firms that are profitable and growing rapidly.

Active managers can also create a customized investment strategy that meets their clients’ comfort levels. This approach will protect against the risks of being on the downside of a bear market, such as the one caused all markets to plunge in value between 2007 to 2009.

“The objective of active management is to develop a protection strategy so that you won’t go down as much as the market goes down, and create a strategy in place to live through a downturn,” Chernish said. Adequate cash reserves, liquidity over time, and cash flows should be built into an individual’s portfolio. If you must index, be prudent and index with only a portion of your money.

Chernish said her overall goal with her clients is to “preserve, protect, and increase” their assets. She achieves that by conducting extensive research.

“It’s a very, long intricate process which I have refined over the years,” she said, “and it’s always subject to learning statistically, analytically, and fundamentally what’s right for my clients.”

If you’d like more information about active management strategies for your investments, please contact Anne Chernish at anne@www.anchorithaca.com or visit Anchor Capital Management, LLC at anchorithaca.com.