Is Active Management Dead?

Just as with subprime mortgage loans and many highly leveraged financial institutions, actively managed mutual funds seem to be one of the big losers in the recent financial crisis. Investors, disillusioned at active funds' failure to protect them during the last market downturn, are increasingly abandoning actively managed funds in favor of almost anything else, including bonds, index funds, and exchange-traded funds. And the sheer magnitude of this trend may surprise you.

Throwing in the towel
According to data from the Investment Company Institute, domestic stock mutual funds have seen net outflows of $8 billion so far this year through the end of June. If this trend continues, stock funds will have experienced five straight years of outflows by year's end. In fact, ICI numbers show that in the 10-year period ending May 31 of this year, investors have yanked roughly $51 billion in net assets out of domestic stock funds. And since Morningstar data shows that domestic stock index funds have had positive inflows every single calendar year since 2001, we can be pretty sure that the funds losing the most in assets are active equity funds.

To be sure, the average domestic stock manager doesn't have much to crow about. According to Morningstar, the average large-cap blend domestic stock fund has underperformed the S&P 500 Index by a full percentage point annualized over the past 15-year period. The average such fund also lost nearly 38% in 2008's bear market -- just the sort of environment where investors were expecting active management to come in handy. After all, why pay more for active funds if their managers couldn't foresee some of the issues surrounding the financial crisis and protect their fundholders? Given the disappointing performance of the average active stock fund over the past decade, it's little wonder that these funds are seeing billions of dollars walk out their doors.

Not so fast
But before you put the nail in active management's coffin, keep in mind that some important trends have materialized in the past decade that help to explain some of the asset loss these funds have experienced. The primary culprit has been the rise of exchange-traded funds. ETF assets have ballooned in recent years and now hold more than $1 trillion in assets. What's more, by the end of 2015, ETF assets are expected to double to $2 trillion, according to a recent report by BNY Mellon and Strategic Insight. A lot of that growth is coming at the expense of active funds, since ETFs offer such meaningful cost advantages.

I won't argue that active fund management doesn't have its problems. It's true that there are many active funds out there with needlessly high costs, poor corporate cultures, and middling performance results. Fortunately, you don't need these funds. The truth is that there are still a small handful of actively managed funds that can beat the market over a long-term time period. These are the funds with low costs, a long-tenured manager or management team, a consistent investment process, and solid results in both good and bad market environments. But they're a bit harder to spot amongst the fray, especially if they've been underperforming in the short run. Here's one of my favorites that hasn't been a dazzler the past two years but still has what it takes to beat the market over the long run.

Small, but special
A lot of funds that focus on higher-quality, more financially stable stocks have found themselves shut out of the biggest gains in the rally of the past two-plus years, but that doesn't mean they are doomed to underperform in perpetuity. Royce Special Equity (RYSEX) falls into that category. This small-cap fund, run by superstar investor Charlie Dreifus, has lagged the small-cap Russell 2000 benchmark by more than 11 percentage points over the past 18 months and ranks behind 94% of its peer group in the past year. But given that Dreifus looks for companies with conservatively financed debt structures and high returns on invested capital, exactly the types of firms that have lagged in the current rally as the market has favored more speculative, risky small-caps, such performance isn't surprising.

However, the fund still looks solid over the long run. Over the past decade, Special Equity beat 95% of all small-cap blend funds, with a solid 10.8% annualized return. Expenses are a reasonable 1.16%. Dreifus has been with the fund since its 1998 inception, using the same valuation-conscious investment process, and the fund has held up extraordinarily well in previous downturns, while still producing decent returns in most bull markets. Those are all keys to long-term success and things you should look for when trying to identify those elusive actively managed funds that can consistently beat the market.

Right now, consumer and tech firms are big in the portfolio. Low-priced tech names such as electronic-component manufacturer AVX (NYSE: AVX  ) and test-equipment maker Teradyne (NYSE: TER  ) both land in the fund's top 15 holdings and sport P/E ratios of less than 11. Likewise, even though the fund lagged its benchmark last year, Dreyfus made several solid stock calls, with major holdings including Lubrizol (NYSE: LZ  ) , Dorman Products (Nasdaq: DORM  ) , and Deckers Outdoor (Nasdaq: DECK  ) all blasting past the Russell 2000 Index in 2010 by wide margins. Earlier this year, Warren Buffett's Berkshire Hathaway (NYSE: BRK-A  ) announced that it will buy out Lubrizol at a 28% premium, marking a significant profit for shareholders. It's this kind of skilled stock-picking that speaks well to Royce Special Equity's future prospects.

Remember that when indexing advocates tell you that the vast majority of actively managed funds fail to beat the market, they're absolutely right. But smart investors know that they only need a few carefully chosen funds that can deliver over the long run. It's true that active funds may not be getting much love nowadays, but don't let that scare you away from the select group of investments that have proved that they can boost your portfolio ahead of the broader market.

For more winning mutual fund recommendations and time-tested personal financial planning advice, check out the Fool's Rule Your Retirement service. You can start your free 30-day trial today.

Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter service. At the time of publication, she owned none of the funds or companies mentioned herein. The Motley Fool owns shares of Berkshire Hathaway. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


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