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March 28, 2016

What Give Actively Managed Mutual Funds an Edge?

American Funds says that some actively managed funds are better than passive (index) funds. Specifically, the company argues that actively managed funds with low expense ratios and high levels of manager ownership (a group that Amercian Funds calls “Select Active”) outperform their index peers. The out-performance is evident over one-, three-, five-, and 10-year rolling periods. I’ll discuss the returns first, followed by the criteria and the caveats to the analysis.
Select Active funds topped the S&P 500 index by an average of 0.30% over rolling one-year periods. Over longer periods, the annualized average advantage for the Select Active funds was 0.70% for rolling three-year periods, 1.04% for rolling five-year periods and 1.07% for rolling 10-year periods. Those funds topped the large-cap index 55%, 64%, 77% and 95% of the time during the respective periods. The analysis was run from January 1996 through December 2015. (A summary of the findings is available on the American Funds website.)
Low expense ratios were defined as using the lowest net expense ratio (NER) for all observed Morningstar categories between January 1996 and December 2015. (We use Morningstar fund data for both our mutual fund and exchange-traded fund guides.) American Funds gives a rule of thumb for low expense ratios as being below 0.99% for large-cap domestic funds. Expense ratios for institutional and advisory share classes would be approximately 25 basis points lower, or below 0.74%.
Manager ownership was calculated using Morningstar screens of manager holdings at the firm level. American Funds assigned a weighted average to do the rankings. An alternative method would be to seek out firms “that had 55% or more assets in the fund family complex in which at least one fund manager had invested a minimum of $1 million.” A fund’s statement of additional information will have this data. You can find it on a fund family’s website, though you may have to look closely to identify the location. While not hidden, it’s not always obvious either. The exact location varies by website.
The numbers are intriguing, but do not represent what an investor would realize in a real-world environment. Sales charges, such as front-end loads (fees for purchasing a fund), are excluded and—if they are levied—would reduce the returns realized by some of the Select Active funds. The portfolios were rebalanced monthly, which is easy to do with a study but is often not feasible in an actual portfolio. The number of funds held was not given and may be more than an individual investor would want to manage or be able to invest in. The analyses shared with me also did not consider mid- and small-cap funds.
Nonetheless, the study suggests a starting point for investors who prefer active management. Low expense ratios reduce the hurdle an actively managed fund has to jump over just to keep its performance even with an index fund.  Higher levels of fund ownership should suggest that the monetary interests of the fund's manager and the directors are aligned with fund shareholders. Still, you should investigate the fund manager’s tenure (longer is preferable), the fund’s size (too many assets under management are a hindrance to out-performance) and whether the fund follows a repeatable process or not (read the fund’s materials and, if available, the manager’s commentary).
The Week Ahead
A small number of S&P 500 member companies will report earnings next week: Lennar Corp. (LEN) and McCormick & Co. (MKC) on Tuesday and Carnival Corp. (CCL), Micron Technology (MU) and Paychex (PAYX) on Wednesday.
The first economic reports of note will be January international trade data, February personal spending and income and the National Association of Realtors’ February pending home sales index. These will be released on Monday. Tuesday will feature the January Case-Shiller home price index and the Conference Board’s March Consumer Confidence index. The March ADP Employment Report will be released on Wednesday. Thursday will feature the March Chicago PMI. March employment data (including the change in nonfarm payrolls and the unemployment rate), the ISM’s March manufacturing survey, the University of Michigan’s final March consumer sentiment survey and February construction spending will be released on Friday.
Fed Chair Janet Yellen will speak on Tuesday. Also speaking will be San Francisco president John Williams and Dallas president Rob Kaplan on Tuesday; Chicago president Charles Evans on Wednesday and Thursday; New York president William Dudley on Thursday; and Cleveland president Loretta Mester on Friday.
The Treasury Department will auction $26 billion of two-year notes on Monday, $34 billion of five-year notes on Tuesday and $28 billion of seven-year notes on Wednesday.

About The Author - Charles Rotblut, CFA is the VP and Editor for American Association of Individual Investors (AAII). Charles is also the author of Better Good than Lucky. (EconMatters author archive here)
The Dolce Whey at Onnit.com!

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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