A Stock Picker's Case for Mutual Funds

I like picking stocks. I've taken time to learn how to do it well, I've picked some great winners over the years, and I've beaten the S&P 500 more often than not.

That shouldn't come as much of a surprise -- this is The Motley Fool, after all, a company founded on the premise that ordinary people can learn to beat professional investment managers at their own game.

But this might come as a surprise: I also own mutual funds. Not just index funds and ETFs, but a couple of actively managed funds as well. What's more, I think many stock-picking enthusiasts could benefit from having a few well-chosen funds in their portfolios.

The case for funds
There are three reasons I'll choose to buy a mutual fund over a stock:

  • To get exposure to parts of the market (typically overseas) I don't know that much about -- and can't spend time researching properly -- but that I need for diversification.
  • To stay fully invested when I'm low on good stock investing ideas.
  • Because I've found a great fund that fits my portfolio.

I usually choose ETFs or index funds for the first two -- they'll beat most active funds most of the time, and I don't have to put much effort into researching them. But every now and then, I run across an active fund I can't resist. Usually, these are low-fee funds with a veteran manager working in one particular corner of the market -- and some have done very well.

The problems with funds
Now, here's the caveat: A lot of actively managed stock funds -- the vast majority -- aren't worth your time and money. Compared to a portfolio of stocks you build on your own, an actively managed mutual fund starts with serious built-in disadvantages:

  • Size. Managing a billion dollars or more is completely different from managing a six-figure retirement portfolio. As individual investors, we can take sizeable positions in small-cap stocks without driving the price up, and we can even buy micro-cap stocks in quantities big enough to have a significant impact on our overall portfolio. It's hard to do that with a billion-dollar fund, and even harder as the fund gets bigger. For example, check out Big Bertha's -- I mean, Fidelity Magellan's (FMAGX) recent holdings. There are a few small stocks in there, but their size and influence on the fund's returns are dwarfed by the fund's enormous stakes in big names like Applied Materials (Nasdaq: AMAT  ) , General Electric (NYSE: GE  ) , and Goldman Sachs (NYSE: GS  ) -- and as you'd expect with a fund full of big-name stocks, its long-term performance has tracked the S&P 500's pretty closely.
  • Fees. Fund fees have come down considerably in recent years, but they can still take a bite out of performance. This is especially true with international funds, where fee ratios frequently exceed 1% even at lower-cost firms like Fidelity and T. Rowe Price (Nasdaq: TROW  ) . That may not sound like much, but compound it over 30 years and ... well, you get the idea.

It's no wonder that the vast majority of active stock funds lag the S&P 500 over longer periods. But "vast majority" doesn't equal "all."

One of my favorite funds
I've been a big fan of Fidelity Leveraged Company Stock Fund (FLVCX) since it was launched, and I was pleased when the Fool's Champion Funds newsletter recommended it a couple years ago. This fund is an unusual beast, investing in companies with sizeable debt loads -- including Freeport-McMoRan Copper & Gold (NYSE: FCX  ) , Waste Management (NYSE: WMI  ) , and Delta Airlines (NYSE: DAL  ) -- but its track record is excellent.

I've had a chunk of my retirement portfolio in this fund for several years now. Although it got hit hard last year, it has performed strongly in the past -- and has bounced back well so far this year. Unless it gets derailed again by credit market problems or Fidelity replaces the portfolio manager, I expect to hold it indefinitely.

If you look hard, you can always find a few funds that manage to crank out eye-popping returns year after year despite these disadvantages. Those are the ones I love to search out -- and the ones you should strive to discover.

For more on investing with funds, read about:

Fidelity Leveraged Company Stock is a recommendation of Motley Fool Champion Funds. See all our other fund picks with a free 30-day trial -- you'll get full access everything Champion Funds has to offer with no obligation.

This article was originally published on July 30, 2008. It has been updated by Dan Caplinger, who owns shares of Freeport-McMoRan and General Electric. Waste Management is a Motley Fool Inside Value selection and a Motley Fool Income Investor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool's disclosure policy is like Linus's security blanket -- well-worn, but soft and oh, so comforting.


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