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How to rebalance your mutual fund portfolio

At the turn of the year, it’s a good time to rebalance your portfolio of mutual funds, which is where most people keep their investments. 

Here’s a key question: Do you have the right proportion of stock versus bond holdings to line up with your appetite for risk? Just as important: Do you have enough good, actively managed mutual funds to give you a shot at outperforming the market? 

To listen to some, active funds are a waste of time because so few do as well as their index benchmarks -- most often the Standard & Poor’s 500. Passively managed stock index mutual funds are all the rage because actively managed funds seldom outpace them. 

Kenneth French, the noted Dartmouth economist, has argued for choosing index funds over active ones. If you pick active funds, he said, “You should expect to lose. It’s really hard to identify the great managers. You are wasting your time and money trying to beat the market.”

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Index funds are called “passive” because their stock transactions are on autopilot. They simply buy and sell holdings to mirror their underlying indexes. Unlike active funds, they don’t need cadres of well-paid researchers and managers to select stocks. So most index funds have fees that are a lot cheaper than their active counterparts.   

But that doesn’t mean you should forget about active funds, provided you pick the right ones.

As you go about your rebalancing exercise, here are two reasons to invest in active funds: They do better during certain periods (although we’re not in one of those now), and regardless of the investment cycle, there are techniques to find the right active funds. After all, some active funds do outperform the indexes. If just 20 percent of active funds beat their index, that’s where you should look for the good ones, which could make up a fifth of your portfolio, or more.

The largest mutual fund, Vanguard 500 (VFIAX), and the largest exchange-traded fund, SPDR S&P 500 (SPY), follow the S&P 500. Once upon a time, actively managed Fidelity Magellan (FMAGX) wore that crown, yet Magellan doesn’t now even figure in the top 25 roster of funds and ETFs. 

Indeed, the gap between active and passive performances is breathtakingly wide. As of midyear, 85 percent of large-capitalization funds failed to best the S&P 500, according to S&P Dow Jones Indices.

But it’s a comfort that market-beating active funds can readily be found. When giant investment firm T. Rowe Price did a study of 18 of its active funds over 20 years ending in 2015, it found they did better than their benchmarks, even after fees. While this sounds like a self-serving finding, fund researchers at Morningstar agreed with Price’s methodology and conclusions.

Consider one such fund, T. Rowe Price Blue Chip Growth (TRBCX). It outdid its benchmark, the Russell 1000 Growth Index for the entire two-decade period.

Active funds’ fortunes are cyclical. Certainly, history shows that passive does better than active most of the time, but not all of the time. Active funds occasionally do better, according to a paper by Scott Opsal, director of research at Leuthold Group.

The last time this happened, Opsal’s research indicates, was from the second quarter in 2013 through 2014’s second period. Before that, active funds did better from 2004’s fourth quarter through 2006’s second, 2000’s second through 2002’s third and 1991’s fourth through 1994’s second. “There is a to and fro,” Opsal wrote.

During those spells of superior returns, certain factors usually are at work. Among them: Small caps are beating large, international stocks are ahead of U.S. ones and value is outdoing growth. In all three cases, stock-pickers have better odds of outpacing the market because it takes some savvy to unearth the best opportunities.

Stock-pickers also do better when good advances are spread more evenly, not concentrated is a small group of stocks, Opsal discovered. Concentration was big in 2015. Last year, four monster growth stocks propelled the S&P 500, whose other members were doing just so-so. These were the famous FANG stocks: Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google parent Alphabet (GOOG).

Last year, Amazon and Netflix more than doubled, and the other two advanced by more than a third. This year, their performances are more tepid, ranging from 4 percent higher for Alphabet to 13 percent for Amazon.

Maybe another stretch of good fortune lies ahead for active managers, although the signs are far from clear. This year, value stocks are doing a bit better than growth. The same goes for small stocks over large. International shares, however, are mostly on the downswing, compared to U.S. stocks.

How to find the right managers. Defenders of active funds argue that good management can deliver better returns than the market because, yes, these savants can find promising investments that will deliver far better than a blind match of index holdings can. Otherwise, “you’re asking the indexes to take care of you, but there’s no human component” striving to make that happen, said financial adviser Joshua Rogers, founder and CEO of Arete Wealth Management in Chicago.

Winning streaks don’t last forever, of course. Famously, Bill Miller of Legg Mason had a 15-year run beating the S&P 500 through 2005. Then came the financial crisis, and Miller stubbornly stayed with financial stocks, figuring that with their beaten-down share prices they were good value plays and would soon recover. He was wrong, and his fund got slammed.

How to find the right active funds. Here are four things to look at:

  1. Long-term record. True, as the boilerplate warning language on investments says, past results do not guarantee future returns. Just ask Miller. But a fund’s ability to deliver consistent outperformance argues that its managers know what they’re doing. Look at the T. Rowe Blue Chip fund: While it lags the S&P 500 lately, it outdoes the broad-market index over three, five and 10 years annualized.
  2. Management. Has a good manager been there for a number of years? The T. Rowe fund’s manager, Larry Puglia, has been in charge since its inception in 1993.
  3. Do the managers eat their own cooking? That is, do they have a significant personal financial stake in the fund they’re steering? A Morningstar study found that fund performance improves with the level of their managers’ stake. Puglia, for instance, has more than $1 million invested in the Blue Chip fund. To find that out, you need to call up something called the Statement of Additional Information on a particular fund, easily located by an Internet search.
  4. Low costs. Study after study has confirmed that active funds that charge less tend to do better than expensive ones. Active funds’ fees average around 1.3 percent yearly, which is a drag on your results. The T. Rowe fund charges just 0.71 percent, almost half the average.

Even Burton Malkiel, the legendary Princeton economist who was one of the fathers of the indexing industry, has spoken about the advisability of keeping at least some money in active funds, provided that they’re low-cost. 

Bottom line: It’s both possible and worthwhile to find funds that can beat the market.

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