Beating The Bear

Academics have long scorned actively managed mutual funds. Instead of spending money on managers who attempt to beat “the market” (however that is defined), academics argue, investors should stick with index funds. Lately the index proponents have embraced exchange-traded funds, benchmark trackers that have been attracting a flood of assets. Are the academics winning the argument? Will active funds eventually wither away? Not likely. Actively run funds are alive and well.

For starters, many active fund companies have been drawing huge inflows. The largest actively managed fund family, by assets, is American Funds, which had inflows of $74 billion in 2007, according to Financial Research Corporation. Other active families that drew more than $10 billion in new assets for the year included Franklin Templeton, T. Rowe Price and Dodge & Cox. Financial Research says that active funds currently have $7 trillion in assets, and the figure should reach $12 trillion by 2012.

To be sure, ETFs have appeal. In 2007, ETFs enjoyed inflows of $71 billion, a big number for an asset class that has only $600 billion in total assets. But the strong showing by ETFs does not necessarily mean that active funds are in decline, says Brian Reid, chief economist of the Investment Company Institute, the mutual-fund trade group. “Investors who used to hold individual stocks directly are switching to ETFs,” says Reid.

Actively Popular

Part of the appeal of active funds in recent years has been simple: performance. During the 10 years ending in 2007, 48 percent of active large-cap funds outdid the S&P 500, according to Morningstar. This might provide ammunition for the index proponents. But Morningstar notes that the performance varies considerably. During years when the S&P rose more than 10 percent, only 39 percent of active funds outdid the benchmark. But when the market produced a loss or single-digit gain, 57 percent of active funds outdid the benchmark. In 2007, an erratic year when the S&P rose 5.5 percent, 54 percent of active funds outperformed. “In a bear market — which is what we have now — the majority of active funds can easily beat the index,” says Louis Stanasolovich, a financial advisor in Pittsburgh. “Active managers can hold cash and control their risk in ways that an index fund can't.”

Some of the active funds with the strongest long-term records have achieved their results by skillfully holding cash and avoiding risky stocks, says Stansolovich. Active stars include funds from companies such as FPA, First Eagle, Leuthold and Mutual Series. “They have beaten the S&P — and done it without taking much risk,” says Stanasolovich.

Active managers have had noteworthy success with foreign funds. As overseas markets outdid Wall Street, investors poured $208 billion into international funds in 2007. The majority of that cash went to such top-selling active funds as Dodge & Cox International Stock, American EuroPacific and Thornburg International Value. Part of the appeal of active international funds was their performance. In 2007, the average foreign large-blend fund returned 12.79 percent, about 2 percentage points ahead of the Morgan Stanley Capital International EAFE index, the measure that serves as the benchmark for popular funds such as Vanguard Developed Markets Index and iShares MSCI EAFE Index.

The poor showing of the international benchmark points to a weakness of index tracking. Over time, benchmarks can become outdated. The EAFE, which has long been a standard measure for institutions, was designed at a time when pensions had little interest in developing countries. Consequently, the EAFE has no representation in markets such as India, Brazil and Taiwan — some of the strongest performers in the world. While the biggest international index funds avoid the developing markets, active managers have been adjusting their sights, moving assets into the fastest-growing economies in the world.

To be sure, index funds have made inroads in the domestic large-blend category, where S&P 500 trackers have won a large following. According to the ICI, about 40 percent of all large blend assets are indexed. SPDR Trust, an S&P indexer, ranks as the biggest ETF, with $98 billion in assets. Many investors seek to index large-blend stocks because they feel that it is difficult for active managers to outperform in an arena dominated by familiar blue chips.

But outside the large blend category, more than 90 percent of fund assets remain with active managers. In some categories, the penetration of index funds is tiny or nonexistent. Real estate is among the struggling categories for indexers; the fact is, indexers have yet to prove that they can consistently outdo the active managers. For example, despite its rock-bottom expenses, Vanguard REIT, the largest indexer in the field, has underperformed the average active fund during the past five years.

Of the $1.5 trillion in bond funds, 94 percent is in active funds. Part of the reason for the dominance of active funds is that index developers have had a difficult time designing portfolios that match benchmarks for corporate and municipal bonds. The problem is that there are tens of thousands of bond issuers. So constructing a cross section is no easy feat. In light of the obstacles, there is still no index fund tracking high-yield corporate bonds. And tax-free index funds have attracted less than $500 million — while active municipal funds hold $365 billion.

The Star System

No matter where the assets may be flowing, index proponents still argue that picking active managers is a losing proposition because it is difficult to predict future performance. But the evidence is growing that there are ways to spot winners. Consider the famous Morningstar star system. Throughout the 1990s, academic researchers railed against the star system, and conducted studies showing that the Morningstar approach had little predictive value. Listening to the critics, Morningstar revamped its system in 2002. Now the revised star system has a five-year track record, and the results are noteworthy. In nearly every category, funds that held five stars in 2002 went on to outperform four-star funds over the next five years. Four-star funds outdid three-star performers, and so on. For example, the 2002 class of five-star international funds went on to return 20.1 percent during the next five years, while one-star funds returned 18.6 percent. The five-star balanced funds returned 11.1 percent, compared to 9.0 percent for four-star portfolios and 8.1 percent for one-star performers.

Morningstar improved its system by taking some commonsense steps. Before the 2002 revamping, the system only ranked funds according to broad categories, such as taxable bonds. Under that approach, junk-bond funds and Treasury specialists competed against each other. Not surprisingly, the rankings were next to useless. Just because a junk fund outdid Treasuries one year was no guarantee that the results would repeat during the next 12 months. But under the new system, the risk-adjusted return of each junk fund is compared only to peers.

Russel Kinnel, Morningstar's director of fund research, cautions that investors cannot follow the stars blindly. While the stars are determined by past data, qualitative factors can also be important in determining how a fund will do in the future. For example, a fund manager may have quit recently and been replaced by a novice. Then there is little reason to believe that the long-term record can be repeated. To provide additional guidance, Morningstar also publishes its fund picks. This is a list of 180 funds that have been vetted by analysts who take subjective criteria, such as the stability of a fund's management team, into consideration. “The stars provide general guidance,” says Kinnel. “The picks list is intended as a buy list.”

Kinnel says that the picks list has performed a bit better than the star system. During the five years ending on August 31, Morningstar's domestic equity picks returned 14.1 percent, compared to 13.3 percent for the Wilshire 5000, and 12.0 percent for the S&P 500. Taxable bond picks returned 4.9 percent, compared to 4.3 percent for the Lehman Brothers Aggregate index.

Another influential fund rater is Charles Schwab, which publishes a Select List, the most appealing choices based on risk-adjusted returns and subjective factors. Schwab has conducted research on the best ways to pick funds. Risk-adjusted returns provide important guidance for fund pickers, says Michael Iachini, Schwab's director of investment manager research. Schwab also found that the size of a fund — and the size of its company — can be an important consideration. For years, researchers have said that small-cap funds with small portfolios have an advantage. But Schwab has found that the optimum size of a portfolio depends on the category of the investment. For example, large bond funds tend to outperform funds with limited assets, says Iachini. “Big bond traders can negotiate for better deals, and get access to the best new issues,” he says.

Schwab determined that big companies have an advantage in managing large value portfolios. Iachini says that big fund families have more research and trading resources that can help to unlock values. Iachini cautions that there are exceptions to the rule; some tiny value funds have produced outstanding results. But he argues that the data trends are helpful in picking the best funds. By using a mix of data, it is possible to identify the top active funds that have a good chance of going on to beat the benchmarks.

MARKET BEATERS

These actively managed funds have outdone the S&P 500 while taking moderate risk.