Should I pay a fund manager for asset allocation or choose a mix of index funds?


Hello, Joanna….

Just ran across your March 2013 comparison of actively-managed funds to index funds.

Your results reinforce other articles I have seen on this subject. But all of them, including yours, leaves me wondering about real-world applicability.

Here’s what I am getting at……  Many financial writers point out that the secret to investing success is a diversified portfolio.  To them, asset allocation is more important than picking THE best mutual fund or ETF.  The results of the past ten years or so tend to support this argument.  Those with all their money invested in equities have basically broken even; however, those with a significant leavening of bonds in their portfolio did considerably better.

This begs the question of who should decide the proper asset allocation mix – and when / if to change that mix to better position the portfolio for the current investment climate.  One could hire an investment adviser to do that, or rely on his / her personal judgement.  Neither alternative offers a guarantee of success.

However, there are many actively-managed “balanced” mutual funds that do exactly that – on an ongoing basis.  They typically hold equities, bonds and cash in varying percentages.  Moreover, they may include large cap, mid cap and small cap domestic equities and foreign equities.  Their bond holdings may be similarly diversified.  T. Rowe Price Capital Appreciation (PRWCX) and FPA Crescent (FPACX) are two such well-regarded funds.  Managers of mutual funds like these take care of the asset allocation decisions for you.  This service is included in the management fee one pays for those funds.

As far as I know, there are no index funds comparable to mutual funds like the two examples mentioned.

So, how should an investor apply the results of your study when considering index funds vs. actively-managed balanced or “go-anywhere” mutual funds?  I understand the concept when comparing an actively-managed domestic large cap mutual fund to a comparable index fund (“apples-to-apples”).  The index fund will usually be a better choice.  But when you add the asset allocation question to the mix, then what?

I haven’t seen this question discussed in “active vs. index” articles that I have read.  They seem to be addressing an “apples-to-apples” comparison between similar funds with differing management approaches.  But if portfolio asset allocation is at least as important as fund performance compared to peers, then might not actively-managed mutual funds that do this for you be a better bet than a mix of index funds that a less-knowledgeable individual investor assembles on his or her own – despite the higher management fees?

Would appreciate any thoughts / insights you can provide re: this question!

Thank you.

Phil B.


Hi Phil,

I agree that asset allocation is a very important determinant of investment returns.  There are many different theories on what the optimal portfolio allocation should be.  Some people say 120 minus your age is the percent you should have in equities, while some say far less.  Here’s one that seems reasonable to me:

Since some managers choose very aggressive allocations while others have conservative allocations, you are effectively choosing your own asset allocation when you choose a manager.  I would suggest that if you are leaning toward choosing a money manager with a certain allocation (like 70% stocks, 30% bonds), that you instead just put 70% of your money in a stock index and 30% in a bond index.

I personally prefer to make these asset allocation decisions myself.  Just as there is no evidence that managers outperform the index, there is also no evidence that they have skill in choosing asset allocations so I can’t bring myself to pay them extra for providing this service.

I understand, however, that not everyone is comfortable choosing their own allocation.  Luckily, there are Target Date funds available.  These funds invest in a mix of different asset classes, with the asset allocation optimized for a savings goal at a certain future date.  These funds come in both index and active varieties and change allocation to become less aggressive over time.  Often they are marketed for retirement, but funds like the Vanguard Target Retirement 2040 (VFORX) can be purchased in a regular, non-retirement account and will take care of rebalancing asset allocation for you without paying extra for active management (the expense ratio is only 0.18%).  Just choose the year you plan to spend the money and let the target fund do the rest!

About the Author

Joanna D. Pratt, CFA is an experienced institutional investor.  She holds a bachelor’s degree in economics and certificate in finance from Princeton and an MBA from Stanford.

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