Start with funds that have low expense ratios and whose managers eat their own cooking
There's no secret formula when it comes to selecting the best portfolio managers. But there are some factors to consider that can at least boost your chances of picking someone who's going to outperform.
As a group, actively managed funds don't do much to inspire. Only 37% of actively managed large-cap funds beat the S&P 500 last year, according to Standard and Poor's 2012 Indices Versus Active Funds Scorecard. Over the last five years, that number falls to 25%.
That's not to say there haven't been plenty of opportunities for the funds to outperform. More than half the stocks in the S&P 500 had a total return in 2012 that deviated more than 10% from the index, according to Vanguard. In fact, the majority of stocks have deviated by at least that much annually since at least 2000.
“It doesn't matter if it's an up or down year for the index; the opportunity set is there,” said Jim Rowley, senior investment analyst at Vanguard.
There's both the opportunity to outperform by owning those stocks that outperform by more than 10% and the opportunity to underweight or not own the ones that fall more than 10%, he said.
Finding the manager that can consistently make the most of those opportunities may seem like a fool's errand, but it's important to remember that there are still managers out there worth investing in, said Dan Culloton, senior mutual fund analyst at Morningstar Inc.
“Proponents of passive management are right when they say the average manager will not beat the benchmark over the long-term once you deduct fees,” he said. “Not all managers are average though.”
To find the above average managers, advisers should focus on things like costs and whether a manager is confident enough in his own strategy to invest in it.
“You can increase your odds of picking an active manager by just applying a handful of very strict fundamentals,” Mr. Culloton said.
By looking at just the funds with the expense ratios in the bottom quartile, for large-cap funds that means less than 76 basis points, you'd find that 41% of managers have beat the S&P 500 over the last five years, according to Morningstar.
If you only look at funds that eat their own cooking, meaning they invest at least $500,000 in their own fund, the number jumps to 45%.
The real eye-opener, however, is when you look at funds with both low expense ratios and managers who invest at least $500,000 in their own funds.
That leaves only 55 funds, most of which have household names like American Funds, Fidelity, T. Rowe Price, and Vanguard. But more than half of this group, 55%, has beaten the S&P 500 over the five years ending March 26.
If you stretch the time horizon to 10 years, the group does even better. Nearly seven out of 10 of these funds beat the S&P 500 over that time period.
Obviously the screen isn't foolproof. There are still some chronic underperformers like the $8 billion Janus Fund (JDGAX) and the $482 million ClearBridge Equity Fund (SABRX) that pass the test. Still, it's a good starting point.
