A reader asked the following question about advisers using actively managed mutual funds;
(could you) discuss a little about Planners using funds that are actively managed, but really only out perform 3% or so as opposed to "real" investors that go off script. I have viewed this as a business risk v. doing what you should for your clients.
I'm not entirely sure what is being asked so I'll just wing it. Broad based, actively managed funds are very problematic. There are of course the statistics about actively managed funds lagging the market. That seems like the sort of thing that while probably true there might be more to the story like risk adjusted returns and maybe even data mining.
From my point of view the problems arise in constructing the portfolio. If you own a bunch different funds you may still have all sorts of overlap. Many fund companies honing in on the same areas and then those being the wrong areas to favor is far from an outlying event. Additionally if you own several funds from the same fund company the chances of the same names showing up (it's the same research department after all) in funds with seemingly different objectives is also far from an outlying event.
Another issue is never knowing what you own. Most funds disclose holdings two or four times a year. You're always several months behind knowing what is in your funds. Also there is no way to do any forward looking analysis with an actively managed fund. How many times have you heard someone from Morningstar say something along the lines of "well the fund had a bad year but we think the manager will turns things around so we like the fund." That could turn out to be true of course but it is a guess. There is no way to do forward looking analysis on a fund, no way to know what a manager will do six months from now.
This is not to say that active fund managers are bad or whatever, some are obviously better than good, some are mediocre and some are lousy. The issues above regarding holdings and overlap apply to whatever mutual fund you think is the best one. It may not be a problem very often but it is always an issue.
This is not, in my opinion, necessarily the same type of obstacle for narrower funds. A domestic financial sector fund is always going to own domestic financial stocks--maybe the right stocks or maybe not but it will always be a narrow proxy for, in this case, domestic financials.