If you are fed up with the high fees and mediocre performance of your mutual funds, you’re not alone. Over the past decade, investors have moved trillions of dollars from traditional actively managed mutual funds into exchange-traded funds (ETFs), most of which passively track the stocks in an index such as the S&P 500, guaranteeing your returns will closely match those of that index. ETFs, which had net inflows of $502 billion last year, have topped inflows of mutual funds in eight of the last 10 years…while equity mutual funds saw outflows of $289 billion last year.
It’s obvious why so many investors are dumping their mutual funds—ETFs tend to be cheaper, easier to evaluate and offer better long-term performance than most mutual funds. Over the past decade, 86% of US stock mutual funds failed to outperform comparable indexes. And among large-cap stocks, which form the core of most investors’ portfolios, 94% of largecap mutual funds underperformed.
Not so fast, says fund expert David Snowball, PhD, the publisher of MutualFundObserver. com. He thinks you shouldn’t give up on mutual funds just yet. There still are plenty of great ones if you know how to choose wisely. And with the stock market likely to be turbulent in the years ahead, those funds can offer you significant advantages over passive ETFs beyond just a chance to beat the market, including losing less in down markets, controlling volatility and producing solid performance with lower risk.
Bottom Line Personal asked Snowball to explain how he finds great actively managed funds and which ones are at the top of his list now…
EVALUATING MUTUAL FUNDS
Many investors pick mutual funds that have the highest returns, or obsess over hot funds that have trounced the market. That’s a set-up for sleepless nights. To earn sky-high returns, a fund manager must take gambles, which means that there will be sharp ups and downs and certain years when the funds badly underperform the market. Many investors can’t handle this volatility and jump from fund to fund, and that leads to below-average returns in their portfolios. But there is a smarter way to pick actively managed funds…
Figure out your risk tolerance and what kind of returns you need to achieve your financial goals. Most major brokerage firms, such as Charles Schwab and Vanguard, have online questionnaires that can help you do this.
Look at a fund’s risk-adjusted performance, not its regular performance. It tells you how well a fund performed given the amount of risk the manager took to earn those returns. We call funds with consistently top-tier riskadjusted performance “Great Owls”—their success tends to reflect their managers’ wisdom, shrewd instincts and caution. In many cases, the regular, longterm performance of Great Owl funds is superior to their benchmark indexes, but I like them for several other reasons…
They are easier to hold long term because they shine when the market gets rough, providing considerable downside protection in sell-offs. They can lower risk and sidestep big losses by avoiding vulnerable sectors or by holding cash, neither of which an ETF can do. Down periods are when investors are most vulnerable to making mistakes—selling in a panic and not having the courage to keep adding new investment money.
They have consistent and replicable strategies so they are not dependent on a single star manager. If the manager leaves or retires, other talented people at the investment firm can take over.
They can serve as core holdings…or if your portfolio is already dominated by broad, plain-vanilla index funds and ETFs, you can use Great Owls to introduce diversity and risk control. You can see a free list of Mutual Fund Observer’s Great Owl funds at Member. MFOPremium.com/greatowls.
SIX OF MY FAVORITE GREAT OWL FUNDS NOW
These funds have delivered top-quintile risk-adjusted returns in their categories for periods of three, five and 10 years…
Setting the bar high: Jensen Quality Growth Fund (JENSX). Few investment managers are as picky as this nearly three-decades-old fund, which mixes high-quality large-cap growth and value stocks. The 25 to 30 companies that the fund invests in must generate 15% return on equity for 10 consecutive years, a metric so difficult to achieve that even firms such as Amazon and Facebook don’t make the cut. The six-manager team also requires companies to have consistent profits, strong demand for their products and services regardless of the broader economic outlook, and a bulletproof balance sheet. Top holdings: PepsiCo and medicalequipment maker Stryker Corp. Performance: 16.6%.* JensenInvestment.com
Socially responsible: Parnassus Endeavor Fund (PARWX). Jerome Dodson launched this fund in 2005, convinced that highly ethical companies that act in the best interest of shareholders are the most profitable investments over the long run. This strategy is known as ESG (for environmental, social and governance). This large-cap value fund does not invest in businesses that derive revenue from alcohol, tobacco, weapons, gambling or fossil fuels. The portfolio consists of about 40 companies that have a positive environmental impact and strong corporate governance policies and treat employees well. Top holdings: Charles Schwab and Merck & Co. Performance: 19.1%. Parnassus.com
Three-legged stools: Akre Focus Fund (AKREX) invests in growth stocks of any size, but each of the 20 to 25 companies in the portfolio must be “three-legged stools.” The first leg consists of a business model that can generate strong annual earnings growth over the long haul. The second leg is strong shareholder-friendly management…and the third is the ability to reinvest cash in growing the business and getting superior rates of return. With 40% of its assets in financials and nearly 20% in real estate, it’s an effective way to diversify if you own a lot of Big Tech stocks. Top holdings: Mastercard and Moody’s Corp. Performance: 19.6%. AkreFund.com
Medium-size Buffett: Madison Mid Cap Fund (GTSGX). This is the type of prudent fund with a longterm approach that a young Warren Buffett might have run. Manager Richard Eisinger focuses on about 30 companies with lasting competitive advantages, conservative accounting and strong free cash flow. He prefers midcaps because they offer the stability and mature management of large-caps but the growth potential of small-caps. The fund tends to lag in strong bull markets but makes up for it during rocky times. Insurance companies are a favorite here. Top holdings: Liberty Broadband and Markel Corp. Performance: 14.4%. MadisonFunds.com
Tiny titans: Needham Small Cap Growth Fund (NESGX) hunts for undervalued, fast-growing companies, mostly micro-cap stocks with market capitalizations under $500 million, that are ignored by analysts. The managers find these companies, often in the tech sector, when they still are private. With assets of $282 million, the 50-stock fund can move in and out of positions quickly. The managers keep volatility under control by holding large amounts of cash if market valuations don’t look attractive. Top holdings: Semiconductor equipment maker Photronics and engineering software maker PDF Solutions. Performance: 19.1%. NeedhamFunds.com
Balance overseas: WCM Focused International Growth Fund (WCMRX) invests its 35-stock portfolio mostly in developed nations, mixing reliable, slower-growing large companies that dominate industries with faster-growing, more volatile upstarts. Manager Paul Black looks for companies with strong corporate cultures and the ability to take market share from competitors. Top holdings: LVMH Moët Hennessy Louis Vuitton and Taiwan Semiconductor Manufacturing. Performance: 13.7%. WCMInvestFunds.com