In investing as in life, brainpower isn't everything. Just ask Mike the headless chicken. This fantastic fowl survived for 18 months without a brain -- or nearly anything else above the neck. Like Mike, investors can get along surprisingly well without the formidable smarts of professional money managers and their actively managed mutual funds. In fact, passively managed funds may provide even better returns. No wonder they've recently surged in popularity.
Rather than relying on a fund manager's judgment to assemble a portfolio, passive funds simply follow an index. If the index adds or drops a certain company, so does its corresponding fund. (Some active fund managers secretly mimic indexes, too -- although they charge far more for the privilege.)
Despite their big brains, savvy Wall Street types often have trouble beating the overall market. The majority of managed mutual funds have long lagged their broad-market index brethren in long-term performance. As market observer Mark Hulbert recently noted, "My three decades of tracking investment advisers has shown that, over long periods of time, about one out of five advisers are able to do better than simply buying and holding an index fund."
According to Morningstar, during the decade that just ended, actively managed funds dropped in market share from 89% to 78%. Along with increased interest in passive investing in general, sector funds have especially embraced the trend. Exchange-traded funds (ETFs) helped boost the market share of passive sector funds (compared to active ones) from 1.5% at the beginning of the decade to 35% at its end.
Proceed with caution
Good index funds and ETFs give you instant diversification, often accompanied by low fees. Just be careful when you start looking at narrower segments of the overall market. Particular niches' returns can vary wildly from those of the overall market, and not always for the better. In addition, many sector funds and ETFs charge more in fees than broad-market funds.
Also, not every investment that looks like an ETF actually behaves like one. HOLDRs were created to invest in a set group of companies in a particular category, with no changes in holdings aside from disappearances because of mergers or bankruptcies. As you might imagine, over time companies will go belly-up or get bought out, changing the composition of the fund -- and often leaving it with significantly fewer holdings.
The Internet HOLDRs (HHH) fund, for example, has only 13 companies in it now, with the top three, Amazon.com (Nasdaq: AMZN), eBay (Nasdaq: EBAY), and Yahoo! (Nasdaq: YHOO), making up more than 70% of its value. Five other companies in the HOLDR collectively make up just 3% of its assets, including E*TRADE Financial (Nasdaq: ETFC).
That narrow focus can be great if you're looking for very concentrated exposure to a certain industry. But if you'd like to cover more of the breadth of the industry, you'll need to look elsewhere. Internet stocks and other fast-changing sectors might also not be ideally suited to passive investments. As the fortunes of various niche companies rise and fall, you might want an active manager making trading decisions.
As an actively managed alternative, consider the Kinetics Internet (WWWFX) no-load fund. It's invested in about 100 companies, and its managers are free to add companies that seem like compelling buys, and sell companies that exhibit red flags. Its holdings recently included Baidu (Nasdaq: BIDU), EMC (NYSE: EMC), and Time Warner (NYSE: TWX).
If I only had a brain
Warren Buffett has recommended broad-market index funds for most investors, thanks to their simplicity, low cost, and market-average returns. Still, it's tempting to look beyond them and hope for better returns. Some fund managers do boast strong records.
Consider a compromise: Invest a big chunk of your money in broad-market indexes (covering both domestic and international stocks), then tack on some carefully chosen managed funds and individual stocks. That way, you'll respect the power of passive, headless investing, while also benefiting from the insights of the market's brightest brains. As Mike could tell you, losing your head isn't always a bad thing.
