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Actively managed funds require a steel stomach

To beat the indexes, investors have to endure a wrenching ride

Nov 19, 2013 @ 12:57 pm

By Jason Kephart

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Long-term investors had about a 1-in-5 chance of outperforming major market indexes over the last 15 years. To do so, they would've had to hold on through some tough times.

The Vanguard Group Inc., which manages more than $650 billion in actively managed equity mutual funds, or more than Pacific Investment Management Co. manages in all its mutual funds combined, recently looked at the 1,540 U.S. stock funds that existed in 1998 and found that it takes a strong stomach to reap the benefits of active management's outperformance.

First of all, picking a fund that's going to be around in 15 years is tough.

Of those 1,540 actively managed stock funds that investors could've picked in 1998, only 894, or 54%, still existed at the end of 2012.

Picking one that's going to outperform is even tougher.

Only 275 of the mutual funds that existed in 1998, or 18%, have produced returns greater than their respective benchmarks over the 15-year period ended in 2012, according to a Vanguard study released last week.

Having the guts to stick with a fund throughout its ups and downs might be hardest of all.

Almost all of the funds that beat their benchmarks over the 15-year period did so with some missteps along the way. All but eight of the 275 funds that outperformed suffered at least five calendar years of underperformance over the period and 181, or 65%, suffered at least three consecutive calendar years of underperformance.

Those bouts of underperformance are clearly hard for the average investor to swallow. That's why investor returns, which Morningstar Inc. calculates using mutual fund performance combined with data on investors' purchase and sale of fund shares, almost always trail outperforming funds' actual performance over long time periods.

The $16.3 billion Vanguard Windsor Fund (VWNDX), for example, has an annualized return of 7.24% over the 15-year period ended Oct. 31, which tops the S&P 500 by 2.14 percentage points. But the fund underperformed in 2007, 2008, 2010 and 2011 before rebounding in 2012 to beat the index by four percentage points that year, and has continued that streak year-to-date through Oct. 31, according to Morningstar.

The Windsor Fund's shareholders lost a percentage point of return a year over the last 15 years, though, thanks to not staying the course, or selling when it was down and only buying when it was up.

The key to finding a manager you can stick with is finding one whose process you trust, said Phil Roberts, wealth manager at Round Table Services.

“If you're an active manager, you gain a lot of credibility by sticking to a good process,” he said. “Sometimes that process is in favor and sometimes it isn't.”

As long as the manager is willing to stick with his process through thick and thin, Mr. Roberts said it's likely he's willing to stick with the manager.

“What concerns us is a manager that changes his process when it's not producing returns,” he said. “That's a yellow flag for us. You really want to make sure an active manager is really sticking to the purpose for which you hired them.”

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