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Illustrations by Yarek Waszul for MONEY

3 Ways to Win at the Mutual Fund Game

May 31, 2016

Have investors given up on trying to beat the market? It may look that way. Between January 2014 and March 2016, they yanked $111 billion out of "actively managed" funds and ETFs—you know, traditional portfolios run by stock pickers. At the same time they plowed more than $434 billion into index funds, which simply buy and hold all the stocks in a given market, according to Cerulli Associates.

Yet actively managed portfolios still hold the bulk of all mutual fund assets. And some of the highest-profile champions of indexing—legendary investors like Jeremy Grantham and Jack Bogle, founder of Vanguard and the father of indexing—believe there's a place for active strategies in your portfolio. The key is coming up with the right strategy to improve your odds of success.

How tough is the challenge? Well, over the past decade only about one out of five actively managed domestic and foreign stock funds has managed to beat the indexes they're measured against. Those long odds are one reason MONEY recommends you use low-cost index funds and ETFs to anchor the bulk, if not all, of your portfolio.

Still, there's a benefit to studying the 20% or so of actively run funds that actually succeed over time. After all, there are some areas of the market that aren't easily tracked by an index. There are some parts of your portfolio where you may simply prefer to go with an active manager. And there are some circumstances—for instance, in your 401(k)—when limited choices may require you to look beyond index funds.

Whichever situation you find yourself in, you can use the following five rules for investing with actively managed funds to help you create a portfolio that addresses your long-term need for growth and income while also satisfying any urge you may have to be better than average.

Rule #1: Pick Your Shots

There are a few areas of the market that aren't effectively tracked by benchmarks, creating opportunities for smart managers. You just have to know where to find them.

Graphic notes: Tenures are based on single-manager funds and averages for team-run funds. Sources: S&P Dow Jones Indices, Morningstar Tenures are based on single-manager funds and averages for team-run funds. Sources: S&P Dow Jones Indices, Morningstar 

Look in fixed income. The bond market is quite byzantine. Among corporate, government, municipal, and foreign bonds, there are millions of individual securities, many of which rarely trade. Actively managed bond funds can avoid these illiquid areas, unlike index funds.

They can also sidestep a problem unique to fixed income. In the stock market the more attractive and successful a company is, the bigger its value and the greater its weighting in index funds. In bonds it's the opposite: The more indebted that companies or governments are, the greater their representation in bond funds. This is why U.S. government-related debt makes up around two-thirds of the iShares Core U.S. Aggregate Bond ETF, which tracks the Barclays U.S. Aggregate Bond Index. Yet some fear that government bonds are particularly frothy now.

Active funds such as Fidelity Total Bond and Dodge & Cox Income can go light on Uncle Sam. Both portfolios, which are in our MONEY 50 list of recommended funds and ETFs, keep nearly half their assets in corporate bonds. And both have beaten the index in the past five and 10 years.

Cherry pick overseas. Start with emerging-markets stocks, down around 30% since 2011. "Five-year bear markets are rare, and they're a beautiful opportunity to buy at cheap prices," says Rob Arnott, chairman of Research Affiliates. Trouble is, 21% of the MSCI Emerging Markets Index is in energy, materials, and industrials—commodity-driven groups that used to drive the developing world but no longer do. T. Rowe Price Emerging Markets Stock focuses on faster-growing areas, which has led the fund to tech, financial, and consumer stocks. It has less than 7% of its assets in commodity-related sectors.

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Small international stocks are another category in which the odds have been in active managers' favor. Because these shares are often thinly traded, they are difficult for indexes to include. "Adding foreign small stocks can improve risk-adjusted returns," says Gregg Fisher of Gerstein Fisher. One standout fund: T. Rowe Price International Discovery has outpaced around 80% of its peers over the past five, 10, and 15 years.

Rule #2: Cheaper is better

Graphic notes: Tenures are based on single-manager funds and averages for team-run funds. Sources: S&P Dow Jones Indices, Morningstar Tenures are based on single-manager funds and averages for team-run funds. Sources: S&P Dow Jones Indices, Morningstar 

"If you're looking for active funds that are likely to beat their benchmarks, low-cost funds are a good place to start," says Ben Johnson, Morningstar's director of global ETF research. In a recent study, Morningstar compared the short-, mid-, and long-term returns of actively managed stock funds against index funds, then ranked the results by cost. In every single category, the lowest-cost portfolios had a better chance of outperforming than the most expensive.

Be better than average on fees. Fund fees have been falling across the board, but the typical active stock fund still charges 1.3%. Yet many actively managed funds charge far less. In our MONEY 50 recommended list, the expense ratio for Vanguard International Growth is just 0.47%, vs. 1.36% for its average foreign-fund peer. The fund has beaten its benchmark over the past three, five, 10, and 15 years. Dodge & Cox Stock charges 0.52%—less than half what the average large value fund does—and has outpaced the S&P 500 by 1.5 percentage points annually over the past 15 years.

Save even more. Cheap or not, actively managed funds tend to rack up more capital gains than index funds. So stash your low-cost active portfolios in tax-sheltered accounts such as your 401(k)s and IRAs. "Given how difficult it is to beat the market, you don't want to give up a big portion of those returns to taxes if you can avoid it," says adviser Ben Carlson, author of A Wealth of Common Sense.

Graphic source: Richard Ferri and Alex Benke, €œA Case for Index Fund Portfolios€Rule #3: Less is more

Though the odds are stacked against them, some active managers do find a way to beat the market over the long run. The trick is making sure you don't dilute their results with the performance of their lesser peers.

Limit your wager. Diversifying is usually a smart move—but not when it comes to active funds. In fact, you're better off sticking with just one or two active funds per asset class. When you get to a third, your chances of lagging an index portfolio are really high, according to a study by financial analyst Richard Ferri, founder of Portfolio Solutions, and adviser Alex Benke of Betterment.

Control your emotions. Behavioral finance expert Meir Statman notes that though it's difficult to win with active management, many people embrace the challenge. The key, the Santa Clara University finance professor wrote in What Investors Really Want, is to set a limit on how much money you'll dabble with so that you balance your desire to beat the market with the long odds of successfully doing so.

Statman suggests restricting your active bets to the "explore" portion of your portfolio—that 10% to 25% of your stake with which you may choose to take on added risk.

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