Passive Vs. Active Management

In almost all economic endeavors, the quality of management is generally a key component of a successful operation. Managing a mutual fund is no exception to this rule. The fund investment quality we are going to discuss in this section focuses on two important fund managerial qualities: tenure and structure. However, it is worth noting that a fund's investing style, growth, risk and return profile, trading activity, costs and performance are also all a product of management's efforts. How well management "scores" in all these areas is an important consideration for mutual fund investors.

Managed Funds Vs. Index Funds

To begin with, we need to make a distinction between mutual funds that are managed and those that are indexed. The former are actively managed by an individual manager, co-managers, or a team of managers. The index funds are passively managed, which means that their portfolios mirror the components of a market index. For example, the well-known Vanguard 500 Index fund is invested in the 500 stocks of Standard & Poor's 500 Index on a market capitalization basis.

Which is better, managed or indexed fund investing? Both have their positive aspects. Let us first look at the index variety.

Index Mutual Funds

Index mutual funds are an easily understood, relatively safe approach to investing in broad segments of the market. They are used by less experienced investors as well as sophisticated institutional investors with large portfolios. Indexing has been called investing on autopilot. The metaphor is an appropriate one as managed funds can be viewed as having a pilot at the controls. When it comes to flying an airplane, both approaches are widely used.

Here is how an index fund works. The money going into an index fund is automatically invested proportionately into individual stocks or bonds according to the percentage their market capitalizations represent in the index. For example, if IBM represents 1.7% of the S&P 500 Index, for every $100 invested in the Vanguard 500 Fund, $1.70 goes into IBM stock. (For more on index funds, see Index Investing.)

David Swensen, an investment expert, author and former chief investment officer of Yale University's highly successful endowment fund, makes a strong case for indexing. In his 2005 book, "Unconventional Success", he concludes that because "most individual investors lack the specialized knowledge necessary to succeed in today's highly competitive investment markets … passive index funds are most likely to satisfy investor aspirations."

Swensen, and a high percentage of investment professionals, find index investing compelling for the following reasons:

•Simplicity. Broad-based market index funds make asset allocation and diversification easy.

•Management quality. The passive nature of indexing eliminates any concerns about human error or management tenure.

•Low portfolio turnover. Less buying and selling of securities means lower costs and fewer tax consequences.

•Low operational expenses. Indexing is considerably less expensive than active fund management.

•Asset bloat. Portfolio size is not a concern with index funds.

•Performance. It is a matter of record that index funds have outperformed the majority of managed funds over a variety of time periods.

Managed Mutual Funds

Well-run managed funds that have long-term performance records that are above their peer and category benchmarks are also excellent investing opportunities. There are a number of top-rated fund managers that consistently deliver exceptional results. Such well-run funds will register very high on the Fund Investment-Quality Scorecard you are learning about in these pages.

It is worth remembering that despite their impressive long-term records, even top-rated fund managers can have bad years. Such an occurrence is little cause to abandon a fund run by a highly respected manager. Typically, managers will stick to their fundamental strategies and not be swayed to experiment with tactics geared to improving results over the short term. This type of posture best serves the long-term interests of fund investors.

In recent years, a number of fund management-related issues have received more public attention in the financial press than in the past. These fall under the general heading of fund stewardship and include such issues as a manager's financial stake in a fund, performance fees and the composition of a fund's board of directors.

While the discussion on these issues is important, there is no universal agreement as to what constitutes appropriate standards of conduct.

By connecting shareholder and managerial interests, having managers investing significantly in the funds they manage seems like a good idea. Likewise, compensating managers on the basis of performance rather than as a percentage of a fund's assets also seems like a good thing. However, there are reasonable arguments that take an opposite point of view on both of these issues. Less controversial is the practice of having a majority of independent directors serve on a fund's board of directors. But here too, there continues to be differences of opinion. The good news for fund investors is that the debates surrounding these issues heighten public and regulatory awareness of what constitutes proper mutual fund stewardship.