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Why should investors consider actively managed investments?

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One of the great ongoing debates in personal finance asks the question: Are investors better off in passively managed investments, which seek to replicate the performance of a specific index benchmark, or in actively managed investments, which aim to outperform a benchmark based on skilled investment selection?

If investor activity is any indication, the past decade has marked a clear victory for the passively managed side. Between 2007 and 2014, according to the Investment Company Institute, index domestic equity mutual funds and exchange-traded funds received $1 trillion in new cash and reinvested dividends, while actively managed domestic equity mutual funds experienced net outflows of $659 billion.

Meanwhile, studies focusing on the average performance of thousands of actively managed funds in the large capitalization universe consistently claim that the average actively managed fund struggles to beat its benchmark net of fees.

In short, passively managed funds have garnered a solid reputation as the more cost-effective and tax-efficient way to participate in the market.

Yet there are benefits to active-investment strategies that earn them a place alongside passive strategies in investor portfolios: Historically, active management has provided opportunities for generating outsized returns in certain market segments and asset classes— for example, within areas of small-cap, small-cap international and emerging-markets stocks, as well as bonds and real estate.

Skilled active managers have the opportunity to look past the indices and find great companies that have management track records, competitive advantages, free cash flow and low levels of debt. While passive strategies buy everything in bulk, active managers comparison shop and hunt for deals.

The answer to the question, then, of active or passive? Both, but manager selection counts.

This type of stock selection may not be as valuable in a rising market, when businesses start to improve across the board, as they did between 2009 and 2014. Recovery creates a rising tide that buoys everything within a given index, regardless of the quality of the underlying businesses.

But during times when rampant growth is not a given, and when there is a substantial difference between the returns of the best and worst-performing stocks, “stock picking” stands out.

In fact, it’s the skilled managers who veer furthest from their benchmark indices who add the most value. This is known as high active share, and research by economists Antti Petajisto and Martijn Cremers has found that while the average actively managed fund lost to its benchmark by -0.41 percent between 1990 and 2013, during the same period, the most active stock pickers beat their benchmarks by an average 2.61 percent before fees and expenses, and an average of 1.26 percent net of fees and expenses.

Active management can also lead to outperformance when interest rates are rising. Historically, during years in which the 10-year Treasury yield rose, actively managed funds have beaten their benchmarks by an average 1.5 percent, and have trailed by about as much in years when rates fell. This may be because rising rates can widen dispersion in performance between the best and worst performing stocks. It may also have to do with the fact that active managers tend to favor small companies, which historically perform better when interest rates rise.

The answer to the question, then, of active or passive? Both, but manager selection counts. Even the folks at the Vanguard Group, the investment company known for its commitment to indexing, acknowledge that there is room for active management in investors’ portfolios, if the average investor is able to select talented active managers with a track record of adding value at a low cost.

In sum, investors would do well to seek out investment firms that offer a culture of excellence, a disciplined philosophy and process—and a differentiated approach to the markets.

Information expressed herein is strictly the opinion of Kayne Anderson Rudnick and is provided for discussion purposes only. This report should not be considered a recommendation or solicitation to purchase securities. Pas performance is no guarantee of future results.

This article was originally published in the April/May 2016 issue of Worth.

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