This column was originally published on March 25, 2004. It has been updated.
Savvy investors like to point out that the typical mutual fund loses out to the broader market over the long haul. Legg Mason Value Trust (FUND:LMVTX), which finished 2003 with its 13th consecutive market-beating year, is an outlier, they argue. It's the exception that proves the rule. Heck, even if actively managed funds do edge past the S&P 500 over certain periods, the odds of that winning streak continuing are slim to none.
Top dogs
Those savvy types are right, of course. Thanks to low costs and superb tax efficiency, passively managed index trackers do have built-in advantages that the typical fund -- with much higher overhead and a tendency to flip stocks at a gains-draining clip -- can't possibly match.
But investor beware: There's less to that observation than meets eye. For starters, who ever said you have to invest in the "typical" fund? After all, the "typical" individual stock is a bad bet, too. Yet people still buy stocks. And if finding the Value Trusts of the world ain't exactly easy like Sunday morning, it's not an impossible dream, either -- in fact, that's exactly what we aim to do in our Motley Fool Champion Funds newsletter, edited by yours truly.
Just ask owners of Fidelity Low-Priced Stock, a fund whose portfolio recently featured the likes of CVS (NYSE:CVS), Ford (NYSE:F), and Safeway (NYSE:SWY). If you had plunked down $10,000 in this far-from-typical fund on April Fool's Day 1990, you'd have had nearly $98,000 at year-end 2003. That same investment in Spartan 500 (FUND:FSMKX), Fidelity's popular S&P tracker, would have amounted to a little less than $43,000.
Or consider Vanguard Primecap, an actively managed large-cap fund whose wide-ranging top 10 features tech standouts Microsoft (NASDAQ:MSFT), Texas Instruments (NYSE:TXN), Adobe Systems (NASDAQ:ADBE), and Micron Technology (NYSE:MU). It also boasts FedEx (NYSE:FDX) as well as Biogen (NASDAQ:BIIB), Guidant (NYSE:GDT), and Novartis (NYSE:NVS) in health care. For the 10 years ended June 2004, this fine fund notched an annualized gain of 16% compared to just 11.8% for the S&P 500.
Not too shabby.
What it takes
Both of those funds are currently closed, unfortunately. The good news is that, while digging up similarly winning market beaters may not be easy, it's not rocket science, either. To make the grade (and stack the odds in your favor), a fund needs a clutch of key attributes -- the kinds of things that any smarter-than-average investor should bear in mind.
Low costs are essential. Funds with loads or luxury price tags go directly to the reject pile. Beyond that, I'm on the hunt for funds that come equipped with seasoned managers who have successful track records of beating the S&P 500 over time with a sound stock-picking strategy. Top-down types who make big and risky bets on the markets need not apply. And funds with managers whose approach to picking stocks changes with Mr. Market's moods also don't make the cut. When it comes to fund investing, the answer, my friends, isn't blowing in the wind.
Moreover, while I'm a big fan of diversification, I generally steer clear of funds that water down their managers' best ideas with hundreds of picks to "control" risk. That way lies mediocrity.
Scandalous scandal
These days, of course, any search for the fund industry's best and brightest has to include an ethics test, too. New York Attorney General Eliot Spitzer's ongoing investigation confirms our worst fears about the fund industry, and if many implicated shops appear to be shaping up, it's far too soon to let bygones be bygones.
Indeed, for my money, any shop that's been implicated in the scandal doesn't deserve your money -- certainly not any more of it. These tainted firms will have to prove over time that they've clamped down on the permissive corporate cultures that permitted serious trading abuses to occur. Good intentions are great, but investors should insist on real results before trusting any of these guys again.
A silver lining
For all that, I'm pretty optimistic about the prospects for industrywide reform. Mandatory redemption fees (which discourage market timing), strict curbs on those nefarious "soft-dollar arrangements," and greater disclosure of how fund managers are compensated are all on the table. And investors may soon be able to learn if their manager "eats his own cooking" by investing in the funds he runs -- a great gauge of whether a manager's interests are truly aligned with his shareholders'.
Even better, while we're all waiting impatiently for the fund industry to reform itself, there's no need to sit idly by. Solid, market-beating funds -- champion funds -- are out there for the picking. You just have to know where to look.
See you in the winner's circle!
Now what?
You can beat the market -- with funds! Take a free trial of Motley Fool Champion Funds.
Champion Funds analyst and editor Shannon Zimmerman owns shares of Fidelity Low-Priced Stock. The Motley Fool isinvestors writing for investors.
