Tips on Choosing an Actively Managed Fund

Looking for a way to unearth actively managed equity funds that will outperform their peers? Look no further. I'm about to share with you a few tips that just might provide you with an edge in doing so.

Before I do, however, I want to reinforce that I strongly believe that the surest route to long-term investment success is simple: keep costs low, diversify broadly, and rely on broad market index funds. And the vast majority of my own portfolio reflects this belief. Let's call it my "smart money" account.

But I enjoy following the markets, and, like many of us, have a notion far back in a dark corner of my brain that I might just be smart enough to select a long-term winner or two. So I have a small (less than five percent) portion of my portfolio that I call my "fun money" account, in which I allow myself to try to do just that.

Whether you're searching for a fund because you have your own fun money account, or because you just don't buy the indexing philosophy, there are some screens you can apply to your search that may ever-so-modestly increase your odds of success.
Obviously the first thing you'll want to consider is expenses. A few months ago I wrote that investors should limit their search to funds with expense ratios that are 50 to 75 percent of their category averages, and that's as high as I'll go. I don't care how compelling a manager's track record is, the correlation between below-average costs and above-average returns is too strong to ignore. Keeping costs as low as possible is essential.

Secondly, I consider the manager. A long track record of relative success is important, certainly, but only part of what I look at. How much are they turning over their portfolio? Again, I look for a turnover rate that's about half the industry's average, which rules out any fund with a rate of more than 50 percent or so. Keeping turnover low keeps turnover expenses in check, and also minimizes any taxes I might owe.

I also like to read what the manager was telling shareholders during the rough patches. Over the long-term, there will inevitably be periods in which even the best fund managers struggle, so I go back and read the fund's annual reports for the years in which the fund performed poorly. In those times, I want someone who communicates clearly and candidly about what went wrong and why -- not excuses about how his or her brilliance was thwarted. To a certain extent this is subjective, but in my experience someone feeding you a line of, um, horsepucky, is much like Supreme Court Justice Potter Stewart's line about obscenity: it's hard to define, but I know it when I see it.

Finally, I consider the character of the fund organization: do they seem to consider themselves stewards of their investors' assets, or are their customers merely sheep to be fleeced? Here, actions speak far louder than words.

Do they bring out funds that seek to capitalize on the investment fad of the day, or do they stick to their own market niche? Do their funds' expense ratios fall as assets increase, or do they keep all the economies of scale to themselves? Do they let funds grow exponentially, maximizing their own revenue, or do they close them to protect current shareholders?

Fund closings are particularly illustrative of an organization's character. Obviously, fund managers are not big fans of closing their funds to new investors, because doing so deprives them of higher management fees. But closing a fund provides a great deal of protection to current shareholders, because the larger a fund gets, the smaller the universe of stocks that the manager can choose from. History is rife with funds that provided stellar returns when it was small and nimble, only to falter badly when assets swelled.

So while I'd never consider buying a fund from an organization that never closed a fund, neither would I purchase one from firms that announce fund closings weeks or months in advance. An announcement from a manager that they're closing a popular fund four or five weeks from now tells me one thing: they're trying to accumulate as many assets as possible in the interim to boost their revenues. If a fund needs to be closed to protect shareholders, the only proper thing to do is to close it immediately. Plain and simple.

No, I don't suffer from the delusion that the above criteria materially increase the odds of success in my fun money account. The screens above are simple common sense, and, honestly, they do nothing more than help you separate the managers who try to keep your interests in mind from those who are more worried about their own bottom line.

But even if you are able to identify managers whose motives are pure, the fact remains that, motives aside, their odds are success remain quite long. Which is why I'm not willing to bet the achievement of my long-term goals on my manager selection skills. But there's nothing wrong with having a bit of fun with a small portion of your account along the way, is there?

Image via Flickr user AmpamukA CC 2.0