Investors are routinely faced with pertinent questions about how to best manage their portfolio. Chief among them is whether to select an active manager or passive index fund. As one would expect, the answer depends on a lot of factors.
If you’ve been around mutual funds for any length of time, you know that most investors prioritize metrics like performance potential, fund allocation and diversification when selecting the most viable assets. Far fewer are concerned about the merits of the person selecting the funds. Yet the skill of the fund manager is paramount for investors looking to outgrow the market.
If you’re having trouble navigating an uncertain investment climate, an active fund manager could be your ticket to clarity. As the second-longest bull market in history runs out of steam, an active approach to investing that relies on the skill of established fund managers could be one of your best hedges against instability.
Five Tips for Selecting Active Fund Managers
Below are five key tips for selecting the best active fund managers.
1. Emphasis on Fund Structure and Fund Performance
When it comes to mutual funds, structure and performance are critical to long-term success. Managers who evaluate funds using several criteria are best suited to drive an active portfolio. Investors should zero in on fund managers with an established track record and a high tracking error. The latter maximizes your chances of selecting a manager capable of outperforming their fees.
In other words, you don’t want to work with a manager who builds a portfolio that follows its benchmark too closely (this would equate to a low tracking error).
In terms of fund performance, the Fidelity Select Semiconductors Fund (FSELX) has emerged as one of the biggest winners. Over the last three years, it has returned more than 25% while maintaining a low expense ratio.
2. Skin in the Game
People who have a stake in the outcome are more likely to be motivated to work hard to achieve their desired result. This is no different for fund managers. Investors should therefore seek out managers whose compensation is tied to how well their fund performs.
In other words, you should work with managers who get paid more when your portfolio outshines the benchmark it is tracking. A manager’s level of investment in the funds they select for you is also an important consideration in determining their level of commitment.
A simple evaluation of assets under management reveal Pimco Total Return Fund (PTTAX) to be the largest mutual fund at more than $263 billion in value. The combination of solid long-term gains and capable management means PTTAX is likely near the top of many fund managers’ lists.
Click here to read about the performance of long-serving mutual fund managers.
3. Disciplined Strategy
The best fund managers use a repeatable strategy in generating investment returns for their clients. They know what works and employ a similar methodology repeatedly to achieve similar results. Managers who lack a concerted strategy suffer from what some call ‘style drift,’ which is the practice of sidestepping one’s mandate to produce short-term returns. The best managers have a disciplined strategy and do not sacrifice long-term results for a short-term gain.
The best way to screen for this necessary quality is to evaluate a manager’s holdings and compare them over time. This can be done by obtaining a 13F filing with the Securities and Exchange Commission.
The Vanguard Mid-Cap Index (VIMSX) is a good example of a mutual fund that employs a reliable and consistent strategy. In this case, it’s investing in a blended selection of U.S. mid-cap stocks.
4. The Importance of Risk
If performance matters to you, then risk is something you just have to live with. The best fund managers use risk to their clients’ advantage while avoiding recklessness and excessive volatility. Once again, evaluating a manager’s tracking error, fund holdings and overall ranking can help you decide whether their risk profile is worth the investment.
That said, it’s always important to gauge how managers treat risks and the types of strategies they employ to help you beat the market.
The PRIMECAP Odyssey Aggressive Growth (POAGX) is a good example of positive risk taking. The fund has generated double-digit returns over the past three years while at the same time outperforming the S&P 500 by a significant margin.
5. Avoid Excessive Trades
Active fund management has nothing to do with how frequently one trades. In fact, investors should opt out of offices that generate huge order books. The more trades your manager makes, the higher the transaction costs and tax liabilities you incur. One of the best ways to screen out excessive traders is by looking at turnover.
Fund managers with high turnover should be avoided at all costs. Active traders not only cost you more money, they might also undermine the direction of your portfolio.
Investors looking for cheap, tax-efficient and diversified funds are often drawn to the USAA NASDAQ-100 Index Fund (USNQX), which does a thorough job of tracking the technology-driven Nasdaq Composite Index. Although you are essentially investing in a fund that tracks closely with the underlying index, the Nasdaq routinely offers solid growth prospects thanks to oversized exposure to technology, biotechnology and other innovative industries.
Want to know if active managers have an edge in the bear markets? Click here.
The Bottom Line
Anyone doubting the advice presented above should consider reading Mutual Fund Performance Through a Five-Factor Lens by Philipp Meyer-Brauns. In that book, Meyer-Brauns finds that the “vast majority of active managers are unable to produce excess returns that cover their costs.” It, therefore, pays to double down on active managers with the qualities listed above.
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