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Top Tips for Active-Fund Pickers

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar. The active versus passive fund debate continues to be a hot topic on Morningstar.com, but as with any heated debate sometimes it's easy to miss the forest for the trees--namely, picking the best fund for your portfolio.

Here with me to offer some tips on picking an actively managed fund is Morningstar's Christine Benz, director of personal finance.

Thanks for joining me, Christine.

Christine Benz: Jason, great to be here.

Stipp: So, we have had a few articles, videos on Morningstar.com recently. We got a lot of reader comments and response on this active-passive debate. It generates a lot of heat. Do you think it's worthy of all that heat that is generating out there on our site and elsewhere?

Benz: Well, I do think it's worth monitoring on an ongoing basis, so if at some point we see the data points clearly lining up in favor of an all-active or an all-indexing approach, that's something that we should all take to heart.

But as we look at the data I think that it's pretty gray overall. Yes, we have seen that active managers as a group have not outperformed, but I do think that there is some room for some active managers to outperform. And I think our fund analyst group has numbers that show that they've done a pretty good job of identifying them.

So, I think, ultimately, it's something worth paying attention to, but it shouldn't trump other factors when you're putting together your portfolio. So, I would still come back to asset allocation and also calibrating your own savings rate and your own withdrawal rate as being probably more important factors for most investors than actually the security selection piece.

Stipp: So what I'm hearing from you than is that you could have an all-index portfolio, you could have an actively managed fund portfolio, or you could have a mix and you probably can still do okay with any of those strategies.

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Benz: Absolutely. But I would say, Jason, if you are going with that all-active portfolio, you need to be very, very selective.

Stipp: So that's sort of the point what I want to talk to you about today and what you should actually look at when you're picking an actively managed fund. It seems to me that the first thing that comes to mind is management, obviously. What kinds of top-level things do you want to look at in assessing these managers?

Benz: Well, certainly manager tenure and you might hear people say, well, look for manager tenure of five years or something like that. I say the longer the better. And the key here is when you're evaluating the management and strategy and performance and everything else, you want to have the most number of observable data points that you can possibly have. So, you want to look for a very long tenured management team. And if it is someone who has been on the job for a very long time, you also want to have an eye on what is the succession strategy? Who are the people backing up this manager who I know who has delivered very good performance over time.

Stipp: And certainly here at Morningstar, we do go beyond those top line numbers of manager tenure and look at maybe some of the squishier aspects of trying to figure out if the manager is good or not. What are some of the other things that might be maybe not as obvious that you should look at with the management team?

Benz: Well, certainly, strategy, so you want to have a thorough understanding of the strategy, and you want to have it to be a strategy that makes sense to you, that intuitively appeals to you. So I know one strategy that I find personally compelling is kind of that contrarian strategy, where someone is looking for high-quality companies but wants to buy them cheaply. So whatever the strategy is, make sure it lines up with the way that you think about the world and make sure that you understand it.

You also want to think about qualities that we call as a group stewardship, so these aren't so much strategy and implementation, but quality of the firm. What is the culture of this firm and is it, as Jack Bogle says, one of salesmanship or is it one of stewardship?

So do they look out for shareholder interests, do they communicate well with their shareholders, do they invest alongside their shareholders, and have they created a culture that people want to work at and work within for any number of years? And that's something that our analysts tackle in their  Stewardship Grades that are on Morningstar.com.

Stipp: Another important thing I know that they look at when they are thinking about stewardship is fees. And I know with index funds, fees are very important. These are basically commodity products you don't want to pay more for something that you can get exactly the same fund across the street for a cheaper rate. But with active management, it's a little bit different. It should be distinctive strategy and execution. So how much should you pay for active managers?

Benz: Well, it's a good question, Jason. I usually say 1% or less for stock funds is a good threshold, and you also want to keep an eye on what I call hidden costs. So funds pay transaction costs, just like you and I would pay to sell stocks, and these can really add up. So, generally speaking, looking for low turnover is a good way to gauge whether a fund is going to have high or low transaction costs; lower turnover will tend to equal some of these lower transaction costs.

For bond funds you want to set the expense ratio threshold even lower than for stock funds, I think 0.75%, or ideally even lower than that, is a good threshold.

Stipp: So it sounds like you're telling me there is not necessarily a connection between how much you're paying and the quality of the management that you're getting, because we hear that sometimes this fund is worth paying up for because it has a great performance record.

Benz: Right. And to me that's kind of a version of looking at past performance and saying that you think that a fund will be able to deliver that performance in the future. When we look at the data on past performance, what we find is that it's not a particularly predictive data point; expenses are. And so if you are casting your lot with a high-cost fund or a low-cost fund, chances are you will identify a better-performing fund by sticking with the low-cost funds.

Stipp: Sure. Another thing, and you mentioned this a little bit before, is the strategy. And I think when you're trying to assess the strategy over time and how well it's done, you are going to see some up periods, some down periods, where there is a divergence with the benchmark or with the category. How do you assess those and whether it's better on the plus side than it is bad on the minus side? How do you balance those out to figure out if the strategy really does work?

Benz: Well, if you're looking at an active fund, I say make sure that it's truly active. So, looking at a statistic called R-squared is one way to try to get your arms around that. It's imperfect I would say.

Eyeballing calendar year returns, though, can be a really powerful way to see if a fund strategy is truly distinctive. You actually want to see those big divergences versus the category peers and versus an index if the goal is to identify an active fund that will outperform over time. Because it's diverged does not mean that it will outperform, but at least it is employing a truly active strategy, and so that's a good starting point.

Stipp: So, certainly, it's great to see a divergences on the upside but likely with an active fund, eventually at some point, you're going to see a divergence on the downside where the fund underperforms. How should I think about that when I'm thinking about investing in a fund, and what if they had a really bad year, should I really shy away from the fund like that?

Benz: Well, probably not, Jason. But I do think you're hitting on an important thing, which is that having the proper mind set, if you are investing in active funds, is absolutely essential. So not only do you need to know and understand the strategy, but you also need to know that there will be periodic periods when it underperforms its peers--sometimes dramatically, and oftentimes what you may see after those periods of underperformance is strong performance. So you have to be able to put up with those lagging periods if you are going to own a fund that's truly active.

Stipp: You have to be willing to hold on for that ultimate benefit.

Benz: Right.

Stipp: Christine, thanks so much for your tips on actively managed funds.

Benz: Thank you, Jason.

Stipp: For Morningstar, I am Jason Stipp. Thanks for watching.