Staying power usually means a lot on Wall Street. But apparently when it comes to mutual funds, hardly any portfolio managers have such mojo.
Mutual funds with managers who pick securities rather than follow an index — so-called actively managed funds — seem to have little or no ability to stay ahead of the competition, even for periods as short as five years.
“Over a longer-term investment horizon, it is very, very hard for a manager to maintain a top quartile performance,” says Aye Soe, senior director of global research and design at S&P Dow Jones Indices.
Small investors might be better off investing with an index fund with low annual expenses rather than with an actively managed one with higher fees. If the higher fees came with sustained outperformance, it might be a different matter. The problem is that when a fund holds the pole position, it doesn’t last long.
Over a recent five-year period, nearly all stock and bond mutual funds studied by S&P Dow Jones Indices failed to stay in the top 25 percent of performers, according to a study authored by Soe this month.
A mere two out of 703 domestically focused stock funds remained in the top 25 percent of performers for the 60-month period ending in September, according to the study. That’s just 0.28 percent! The original 703 had been in the top tier after 12 months.
Don’t even think about investing in those top two funds. The T. Rowe Price New Horizons Fund (ticker: PRNHX) is closed to new investors, meaning those who aren’t already invested in it can’t start now. The other one, Glenmede Large Cap Core Portfolio (GTLOX), requires a minimum investment of $10 million.
The story was similar for fixed income, or bond funds. In eight of the 13 sub-categories, no funds remained in the top 25 percent of performers after five years. Bonds are often divided by credit rating and the duration of the bonds held.
Soe says that the bond market is very fragmented and that there has been “very little research on the (performance) persistence of fixed-income managers.”
What does this mean for a small investor? “The research I have read shows that passively managed funds outperform actively managed ones over the long term,” says Pam Horack, a fee-only financial planner at Pathfinder Planning in the greater Charlotte, North Carolina, area.
Passively managed funds are those which track an index of stocks such as the Standard & Poor’s 500 index. Horack prefers the Valley Forge, Pennsylvania -based Vanguard stable of index funds, which was pioneered by investing legend Jack Bogle.
Horack likes the Vanguard Total Stock Market Index (VTSAX), which tracks a broad index of U.S. stocks and has an expense ratio of 0.05 percent, or $5 for every $10,000 invested annually. That’s far below the average for actively managed domestic stock funds, which is 1.21 percent. The minimum investment for VTSAX is $10,000.
One with a low minimum investment is the Vanguard 500 Index (VFINX), which tracks the S&P 500. It has slightly higher, but still low, expense ratio of 0.17 percent. The minimum investment is $3,000.
Because of the clear benefits of lower expenses, Horack recommends that her clients invest 90 percent of their funds in index-type products. Only when her clients have more investing knowledge and a bigger tolerance for the potential risks of losing money does she discuss actively managed funds.
Is there any room for actively managed funds? “Actively managed funds have a role at certain times, in certain places, and right now that is bonds,” says Rebecca Kennedy, a Denver-based financial planner and principal at Kennedy Financial Planning. Like Horack, she doesn’t work on commission by selling investment products but rather charges a fee for her financial advice.
“It’s because I am worried about the rising interest rate environment,” she says. When interest rates rise, the price of a bonds tend to fall in value. “The bond market is an area where the expertise of knowing the individual securities and the nuances of the market is important.”
All fixed-income securities require deep mathematical knowledge to truly comprehend the risks involved when interest rates move. In addition, the pricing of bonds isn’t always as transparent as it is in the stock market. Kennedy says being a big player in the bond market can be an advantage, so it can make sense to opt for an actively managed fund.
She favors three institutions for such funds: Los Angeles-based Metropolitan West Asset Management, which is part of the TCW Group; San Francisco-based Dodge & Cox Funds; and Pimco in Newport Beach, California.
She steers clear of exchange-traded index funds because she wants portfolios that her clients can implement themselves. With ETFs that can be tricky, because trading such shares requires more mathematical skills, and the markets aren’t open all the time for such securities. Mutual funds are easier because you can decide to invest a dollar amount each month without further calculations.
Still, those looking for low-expense ETFs could do worse than the SPDR S&P 500 (SPY), which tracks the S&P 500 index and has an expense ratio of 0.09 percent. Investors also must pay buying and selling commissions to a broker.
More from U.S. News
9 Hot Dividend Stocks for 2016
Chinese ETFs: 9 Ways to Play the Middle Kingdom
10 Tips for Handling Investments and Divorce
Why Mutual Funds Lost Their Mojo originally appeared on usnews.com