Choosing an Actively Managed Fund

Choosing an Actively Managed Fund
It's like asking a vegetarian to name his favorite cut of beef.

Market-tracking index funds regularly beat most actively managed funds, institutional investors have a third of their stock-market money indexed, and the proposed Social Security private accounts will likely be limited to a menu of index funds. Yet ordinary investors seem oblivious to indexing's success, continuing to keep 86% of their money in actively managed stock funds.

Still hunting for the next superstar stock fund? Trust me, you need all the help you can get, so I called on the collective wisdom of an unlikely group of experts -- some of my fellow index-fund investors.

Their advice: If you are going to buy actively managed funds, stick with funds that have a long-term focus -- and which seek shareholders with the same mentality. To that end, consider these nine criteria. If a fund meets at least seven of the nine, you may have yourself a winner.

1. Cutting costs. If you use a commission-charging broker, you will end up in load funds. If you invest on your own, you should buy no-load funds. But either way, you want stock funds with annual expenses below 1.5% and preferably below 1%, thus ensuring you keep more of whatever your funds make.

Annual expenses are also an excellent indicator of management's attitude toward shareholders. If a fund is hosing you on expenses, it probably doesn't have your best interests at heart.

2. Sitting tight. William Bernstein, an avid indexer and author of "Four Pillars of Investing," argues that low portfolio turnover is as important as rock-bottom annual expenses and no sales commission.

"What you want in an actively managed fund is a real fear of trading costs," he says. "The markets are really very efficient and you don't want to mess with them too much." That's why he likes companies such as Dodge & Cox and Tweedy, Browne Co., both of which offer actively managed funds with notoriously low turnover. As an added bonus, low-turnover funds are typically more tax-efficient.

3. No billboards. Mr. Bernstein also prefers funds that rarely or never advertise, because heavy advertising is a sign that management's chief focus is hauling in a heap of assets.

4. Case closed. Similarly, look fondly on companies that regularly close funds that grow too fast or get too large. Such closings indicate management is willing to sacrifice its own bottom line for the sake of shareholders.

Also try to limit yourself to smaller funds, favoring large-cap funds with less than $5 billion in assets and small-cap funds with less than $500 million. "Once a fund gets too huge, it becomes impossible to beat the market, because the fund is forced to own the market," argues Larry Swedroe, an investment adviser in St. Louis and author of four books, all of which advocate indexing.

5. Keeping it private. John Bogle, founder of Vanguard Group in Malvern, Pa., and the fund industry's most famous proponent of indexing, advises sticking with fund companies that are privately held, rather than publicly traded.

The reason: Fund managers who are part of stock-market-listed companies are often under pressure to deliver regular earnings and revenue growth. That can drive them to engage in dubious tactics like promoting top-performing funds and bringing out new funds in hot market sectors.

6. Limited selection. Mr. Bogle is clearly a staunch supporter of Vanguard, which now has 110 varieties of fund. But he says a more limited array of funds is often a good omen, because it suggests a company isn't greedily trying to pull in assets by offering funds in every possible category.

7. Weighing results. Investors typically put the most weight on past performance. That's understandable. If you are going to buy an actively managed fund, you want evidence the manager is talented, such as a sparkling five or 10-year record. Still, because past performance is such a rotten guide to future results, never pick a fund on performance alone.

8. Counting stars. If you buy a fund with strong performance, make sure the manager responsible for the record is still at the helm. You might even protect yourself against manager turnover by favoring funds run by investment teams.

Mr. Swedroe says team-run funds are also less prone to "style drift," shifting into different market sectors and thereby messing up your portfolio's diversification. Among team-run funds, he likes American Funds, Dodge & Cox, Tweedy Browne and Vanguard Windsor and Windsor II.

9. Erratic behavior. One reason I like index funds is they offer greater certainty. Whatever the underlying index delivers, that is the performance you should get.

By contrast, you want actively managed funds to have inconsistent performance. As Mr. Bogle notes, for funds to beat their category's benchmark index, they need to hold a selection of stocks that is different from the index. With any luck, those stocks will outperform. But because their portfolios don't look like the market, "good managers are going to have inconsistent performance," he says.

Which fund companies meet Mr. Bogle's various criteria? He mentions Dodge & Cox, Oakmark Funds, Royce Funds, Torray Funds and Weitz Funds.

Mutual Admiration

Index-fund aficionados praise actively managed stock funds at these fund families.

FUND COMPANY PHONE

American Funds 800-421-0180

Dodge & Cox 800-621-3979

Oakmark Funds 800-625-6275

Royce Funds 800-221-4268

Torray Funds 800-626-9769

Tweedy Browne 800-432-4789

Vanguard Group 800-662-7447

Weitz Funds 800-232-4161