These Quality Large-Blend Funds Are No Benchmark-Huggers
Investors looking for managers who ignore the S&P 500 should consider these names.
With stocks in bull-market mode and the S&P 500 up 14% so far this year, index investors can be forgiven for feeling pretty good about "owning the market." After all, the core idea of index investing is not to try to outperform the broad market, but rather to embrace the concept that beating it over the long haul is pretty tough to do. And the fact that index funds tend to be cheaper than their actively managed counterparts is an added benefit.
Some fund managers can't resist the urge to hug the index, either, running portfolios with allocations that bear striking similarities to their funds' benchmark. This play-it-safe strategy allows these managers to avoid steep losses relative to the index while often charging higher fees for indexlike returns. For investors, paying higher fees for an actively managed fund that essentially does what a cheaper index fund does makes no sense.
But not all actively managed funds are index-huggers. Some, in fact, are known for ignoring their benchmarks--a true sign of the manager's conviction that he can outperform the market. There is risk in this approach, obviously. Overweighting--or underweighting--a stock or sector can wreak havoc on returns. (See this article for more on the topic of performance attribution.)
So why would investors prefer a fund manager who thumbs his nose at what the rest of the market is doing? One obvious reason is that the manager has shown himself to be adept at stock-picking--having a knack for finding individual stocks that outperform the market. An actively managed fund charging above-index fees while hugging the index has little chance of outperforming, meaning that active managers must differentiate from the index if they hope to beat it. But another reason investors might be drawn to an index-agnostic approach involves how index funds work.
Critics argue that index funds are not the perfect investment tool they are sometimes made out to be. One common knock against index funds is that they force investors to buy stocks that are overpriced and that those stocks, in an index in which stocks are weighted by their market values, make up a larger proportion of the fund's portfolio than they should. With indexing increasing in popularity, it stands to reason that more assets are flowing into stocks that don't deserve them simply by virtue of those stocks being part of an index. (See this video for more on how increased use of index mutual funds and exchange-traded funds increases correlations and can distort stock prices.)
Freedom to Roam
A fund manager who pays little mind to the index has the freedom to own only the stocks he likes, without being force-fed those he doesn't. For some investors, this benchmark-agnostic approach has a strong appeal. They feel that a savvy manager can exploit inefficiencies in the market, and that this can lead to outperformance. Whether this theory holds true is a topic for another day. And fortunately, investors don't have to decide between an index-only or active-only approach. There's no reason one can't use index funds for exposure to some areas of the market and active management for exposure to others.
For those investors who are interested in funds led by managers unafraid to step away from their benchmarks, the R-squared metric can be useful. R-squared measures the correlation between a fund's returns and those of its benchmark. The R-squared scale runs from 1-100, with lower numbers meaning fund performance has a low correlation to that of the benchmark and higher numbers pointing to a high level of correlation. You can find the R-squared for a given fund relative to its benchmark during the trailing three-, five-, 10-, and 15-year time periods by going to a fund's Quote page on Morningstar.com, clicking on the Ratings & Risk tab, and looking in the MPT Statistics section.
Given the widespread use of the S&P 500 as a benchmark, we decided to identify funds from the large-blend category that have the lowest correlation (R-squared) with the index during the past decade--in other words, funds whose performances had the least to do with how the S&P 500 performed. We used Morningstar's proprietary database (using our Morningstar Direct platform, which is geared toward institutional investors) and searched on large-blend funds with Morningstar Analyst Ratings of Gold, Silver, or Bronze, meaning our fund analyst team believes they will likely be above-average performers, or better, going forward. We've also included the Morningstar Rating for funds to indicate whether each fund's approach has been successful in the past. Many of the names on the list will be familiar to regular Morningstar users as they are among the actively managed large-cap funds often mentioned by our analysts in part because of their consistent execution. The lesson is you should at least get what you are paying for if you are going to pay for active management.
Finally, it's interesting to note that correlations to the S&P 500 have risen in recent years for these funds while assets have increased, as well, suggesting that the funds have become more like the benchmark as they've gotten bigger.
|Benchmark-Agnostic Large-Blend Funds|
|Star Rating||Analyst Rating|| 10-Year |
| 5-Year |
| 3-Year |
|Yacktman Focused (YAFFX)||Silver||75.4||77.5||88.7|
|Amana Income (AMANX)||Silver||78.3||88.5||94.6|
|Longleaf Partners (LLPFX)||Gold||81.3||82.6||85.7|
|Data as of 05-07-13 |
Adam Zoll does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.