3 Things Fund Managers That Beat the Stock Market Have in Common

Sep 22, 2015

Recent trends have been unkind to mutual fund managers who try to outperform the market. It turns out that genius is hard to come by.

The 2015 mid-year S&P Indices Versus Active Scorecard showed what these scorecards always seem to show - that passively managed funds, which mirror a broad index, outperform those funds where a human being actively select stocks. In fact, almost two-thirds of active managers who run funds focused on big companies underperformed the S&P 500 index of blue chips over the past 12 months. Over a five and 10-year period, about eight in 10 managers performed worse than the index.

This may be why actively managed funds are having such a hard time attracting investors. In August, actively-traded U.S. equity funds saw $14 billion walk out the door, according to Morningstar, while investors poured almost $5 billion into index funds. (And that doesn't take into account the rampant popularity of index-based exchange-traded funds.)

You centainly don't need actively traded funds to piece together a low-cost, diversified portfolio. In fact you can achieve that goal with just three MONEY recommended index funds: Vanguard Total Bond Market Index, Schwab Total Stock Market Index and Vanguard Total International Stock Index. The charge just a sliver in fees, from 0.09% to 0.22% of assets per year. You can even just put all of your money into a Vanguard target-date fund, which mixes several index funds into a complete portfolio based on your age, for under 0.2%.

Many active managers charge 1% or more.

Nevertheless, there is still a demand among investors for active management. Among domestic stock funds, there's about $3.8 trillion invested in active funds, compared to $2.4 trillion in passive indexers.

If you're going to invest with a stock-picking portfolio manager, you should do so in a way that will optimize your returns. Here are three signs that an active manager might have a shot:

Low Costs

While it's true that a majority of large-cap fund managers lost out to their peers over the past 12 months, there is one group that actually performed on par or slightly better. Over a one-year period actively-traded large cap funds with an expensesbelow 0.3% beat the market 56% of the time, according to Morningstar, while only 40% of funds with expenses greater than 0.5% outperformed.

Over a three-year period, slightly more than half of active funds with an expenses in the 0.41% to 0.5% range beat their benchmark, compared to only a third of all funds above that level.

Costs are ultimately the reason most managers underperform. Before fees, after all, you'd expect the average manager to be at least, well, average.

Skin in the Game

Almost half of U.S. stock funds have no manager ownership, says Morningstar. That means that about one in two managers aren't betting on their ability to beat the market. "The number of managers showing no faith in their process is staggering," notes Morningstar's Russel Kinnel.

Morningstar found that managers who have more than $1 million invested in their own funds tend to outperform those who didn't have an manager ownership at all.

You can find out how much a particular manager owns in his own fund by looking at your mutual fund's Statement of Additional Information.

If you Go Active, Go Active

One problem that investors run into is picking a so-called actively-manged fund that is actually just a closeted index fund. You don't want to be in the business of putting your money into something that's basically a passive fund but with higher fees.

One metric to consider, then, is a mutual fund's active share, which measures just how different a particular fund is from its benchmark. A classic study from 2006 found that those funds with an active share of 80% or higher beat their benchmark by about 1.2% a year after fees.

There's no sure-fire way to do beat the market. But all three of these criteria speak to how effectively a fund is run year after year; focusing on this is better than simply chasing past performance.

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