Why Jack Bogle Is Right… and Wrong

Vanguard founder Jack Bogle is widely considered to be one of the pioneers of low-cost index funds, making the first such fund available to the public way back in 1975. Scores of competing index funds soon popped up on the scene, bringing indexing into the mainstream. Bogle's affinity for index investing has been widely documented over the years. And in a recent appearance on CNBC, Bogle stated that there really is no place for actively managed funds within an investor's portfolio.

Bogle went on to say that actively managed funds have gotten so large that they can't outperform one another, and once higher expenses are added to the picture, active funds simply can't make up that ground and end up underperforming. So is Bogle right? Are actively managed funds a relic destined to be left behind in the investment world's dustbin?

Baby with the bathwater
I agree with Bogle for the most part, but not with his conclusion about the irrelevance of active funds. You can't argue with the fact that most actively managed investments fail to beat the market over the long run. In fact, according to the Standard & Poor's Indices Versus Active Funds (SPIVA) scorecard, over the last five-year period ending June 30, 2012, 65.4% of active large-cap funds trailed the S&P 500 Index while 77.7% of actively managed small-cap funds lagged the S&P Small-Cap 600 Index. And according to the Investment Company Institute, while the asset-weighted average expense ratio for actively managed equity funds is 0.93%, the same expense ratio for equity index funds is just 0.14%.

Given the weight of this data, it certainly appears as though Bogle is correct. Actively managed funds do have some serious disadvantages compared to index funds and exchange-traded funds. But the fact remains that there are a small number of money managers who do beat the market on a consistent basis and who do provide returns that justify their higher fees -- Bogle himself admits this. The problem is trying to identify those managers.

Diamond in the rough
If we follow Bogle's logic that the larger a fund, the more difficult it is to beat the market, then investors should look to more undiscovered funds that aren't burdened by hefty investor inflows. And since higher fees raise the bar for the manager to overcome, investors should stick to active funds with below-average expenses. We should add to this "must-have" list a fund that has a long-tenured manager or management team, a consistent investment process, and a solid track record of stock picking in both good and bad market environments.

One example of a fund that amply meets these criteria is Primecap Odyssey Growth (POGRX). This large-cap growth offering is run by a talented team from Primecap Management, which has a long history of successful investing using the same time-tested approach. The team looks for stocks with solid long-term growth potential that are selling at temporarily discounted prices. Over the most recent five-year period, the fund has churned out an annualized 7.1% return, beating 91% of all large-growth funds. In that same time period, the S&P 500 gained just 4.4%. But despite such an attractive track record, fund assets are still at a very manageable level -- just over $2.4 billion. And while many actively managed funds charge in excess of 1% a year, Primecap Odyssey Growth comes with a reasonable 0.67% price tag.

Health care stocks are the biggest draw in the portfolio here, especially biotechnology firms such as Seattle Genetics (NASDAQ: SGEN  ) , Amgen (NASDAQ: AMGN  ) , and ImmunoGen (NASDAQ: IMGN  ) . Management likes these fast-growing companies because they are innovators, an overriding theme within the portfolio. The team believes that health care is one area in which the U.S. has a competitive advantage over the rest of the world, so that innovation and investment in research and development will lead to new products and services that will increase productivity and profits over time. Primecap Odyssey Growth will have down years every now and then, but the team has demonstrated that they are one of those few, rare managers that can consistently beat the market over time.

Actively managed funds have certainly lost a great deal of their shine in recent years. But that doesn't mean they are undeserving of a spot in your portfolio. Passive and active funds can complement each other in a well-crafted portfolio, adding an additional layer of diversification to your assets. Jack Bogle is right that there is a boatload of things wrong with active funds in general, but he's wrong that these funds have no place at all in an investor's portfolio.

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