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Why should you use an actively managed fund for your 401k? I have read several questions and answers on this and other sites and it seems like it's generally better to go with funds that follow the indices.

Is there a situation when using a managed fund is recommended above investing in actively managed fund?

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  • To quote myself, "One of the arguments in favor of investing in a very low-cost index fund is that you are effectively guaranteed the average gain (or loss :-(, don't forget the possibility of loss). This, of course, is also the argument used against investing in index funds. Why invest in boring index funds and settle for average gains (at essentially no risk of not getting the average performance: average performance is close to guaranteed) when you can get much more out of your investments by investing in an actively managed fund that will give much better than average returns?" – Dilip Sarwate Jul 16 '14 at 2:35
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    The answer here is the same as for non-401k. Unless you believe a particular fund's managers can deliver sufficiently improved results to make up for the higher fees they charge, you should stick with indexing. Fees wind up being a surprisingly huge drag on the fund's returns. – keshlam Jul 16 '14 at 2:37
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For US stocks it's a bit of a gamble. Many actively managed funds underperform the market indexes, but some of them outperform in many years. With an index you will get average results. With an active manager you "might" do better than average. So you can view active management as a higher risk, potentially higher reward investment approach.

On the other hand, if you want to diversify some of your investments into international stocks, bonds, junk bonds, and real estate (REITs) active management is highly likely to be better than indexing. For these specialized areas specialized knowledge and research is needed.

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  • I agree with this comment with the added clause that it likely that the investor is not better than average at picking mutual funds, so it is a gamble with negative expected return (relative to passive investing). In short, passive investing is probably better and people invest in active funds primarily because they are ignorant. – farnsy Jul 16 '14 at 16:11
  • Do you have a source for your second paragraph? – Craig W Jul 16 '14 at 17:00
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By definition, actively managed funds will underperform passive index funds as a whole.

Or more specifically:

The aggregate performance of all actively managed portfolio of publicly-tradable assets will have equal performance to those of passively managed portfolios.

Which taken with premise two:

Actively managed funds will charge higher fees than passively managed funds

Results in:

In general, lower-fee investment vehicles (e.g. passive index investments) with broad enough diversification to the desired risk exposure will outperform higher-fee options

But don't take my wonkish approach, from a more practical perspective consider:

  • What is the advertising budget for actively managed funds vs. passive? Which ones do you see in the media you consume? Compare this to dollar value of assets under control for a shock!
  • Compare the advice given by personal financial advisors that are paid in commission from the fund companies versus that are paid in fees solely by you. (NB financial advisors MUST clearly describe their commission structure if asked, and all registered advisors have fingerprints on file with the FBI [in the US])
  • If anyone could consistently beat the broad market with a similar risk profile, why would they share this investment with other people?
  • If anyone could consistently beat the broad market with a similar risk profile and they wanted to take investments to increase economy of scale, then why would they take such high fees in addition to this benefit?
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  • I agree with your ideas in general but your first assertion is not true. Aggregate performance of actively managed mutual funds only equals performance of passive mutual funds if all assets are held by mutual funds. If assets are held by individual investors, pension funds, etc. with inferior investing skills, active funds can beat passive funds in a before-fees sense. In fact, they do beat passive funds before fees, but not, on average, by the amount of their fees. Also even if a manager can beat the market it can mathematically be best to do it with other people's money and take a fee. – farnsy Jul 16 '14 at 16:06
  • @farnsy 100% accurate. Premise is correct with "managed portfolio" meaning anything that is not a passive portfolio, e.g. including investments that you and I make as individuals. You have correctly found the fallacy in 'result' above which does not directly derive from premise 1 and 2. And perhaps better practical advice would have been "be skeptical of salespeople and understand how they are paid" rather than those bullets. – William Entriken Jul 16 '14 at 16:54

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