What to Expect From an Actively Managed Fund

Note: This article is being re-featured as part of Morningstar's December 2014 Guide to Better Investment Picking special report. This article originally appeared Dec. 2, 2014.

Once it was  Fidelity Magellan (FMAGX). Then it was  Legg Mason Value (LMVTX). Next were American Funds’ domestic-equity funds and then  Fairholme Fund (FAIRX). Each was a flag-bearer for the cause of active management and then each was later abandoned by investors when it failed to meet expectations. These setbacks were met with a slew of articles on how active management was a failure. 

This got me thinking about why the wrong funds get chosen as standard-bearers for active management and why investors often have the wrong expectations even with the right funds. To make the most of an actively managed fund, especially a focused one, you need to understand the needed holding period and likely volatility of performance.

Looking back, you can see failure in the way these funds were chosen as well as in the expectations around them. While American Funds’ domestic-equity funds never inspired dreams of getting rich quick, Fidelity Magellan, Legg Mason Value (now ClearBridge Value), and Fairholme Fund certainly did. They had absolutely amazing returns for a stretch that left indexes in their dust.

Of course, to crush an index, a fund has to be very different from that index, and it’s inevitable that such a fund will also have periods of dramatic underperformance. Yet some investors expect a top fund to trounce the index every year or nearly every year. That’s just not possible. Such unrealistic expectations set everyone up for failure.

In the case of all of these standard-bearers, investors read into past performance and saw a promise, but that just doesn’t make sense. The fact that these funds stayed open even after they might prudently have been closed made the situation significantly worse, as doing so meant that a slew of less-savvy investors came in at the top and then sold after a bad year or two. We’ve found that funds that close to new investors tend to have much better Morningstar Investor Returns.

Fallen Champions
Fidelity Magellan was a heroic fund in the 1970s, 1980s, and early 1990s, but asset bloat and Peter Lynch's departure in 1990 led to a long downward spiral that illustrated just how hard it is for one person to run a $100 billion fund.

Legg Mason Value was all about The Streak. Bill Miller beat the S&P 500 for 15 straight years, thus leaving investors with the impression that he would always stay ahead of the market. However, a key to that streak was Miller's bias against natural resources and his pivot in the late 1990s from value investing to value plus Internet, which ensured the fund did well throughout the 1990s. While the streak was remarkable, the long drought since then shows why you shouldn’t read too much into any streak. Miller’s biases were out of favor with the market for most of the past decade. The fund also was too pricey, too big, and understaffed. We took the fund off our Analyst Picks list in 2001 for those reasons. But the fund's specific problems don't apply to all active funds. There are, after all, low-cost, well-staffed funds with more-manageable asset bases.

While Fidelity Magellan and Legg Mason Value had enough fundamental problems to sink returns for a long time, Fairholme Fund and American’s domestic-equity funds have actually done a fine job for investors. That’s why I find the negative views that they elicit more concerning.

To be sure, Fairholme and many American funds should have closed to new investors. However, they’ve delivered excellent results over the long haul. In a Red Flags column in the November 2008 issue of Morningstar FundInvestor, Andy Gogerty wrote: "We're big fans of Fairholme Fund, but we worry about the latest wave of investors coming in." Gogerty was concerned that new shareholders thought Bruce Berkowitz would whip the S&P 500 every year. Not that we expected the fund to lose 32% in 2011, but it was certain that the fund would have a poor year at some point. The fund quickly rebounded to have strong performance since then and overall, but many investors missed out by fleeing. Until 2011, it was the fund that generated the most buzz among individual investors. Today, it has fallen off most people's radars. To be sure, it's quirky enough that it shouldn't be a core holding for many investors.

American Fund’s conservative well-diversified stock funds don’t often produce extreme performance the way the standard-bearers above do. American appeared to be a shining citadel in 2004 as it emerged from both a bear market and the market-timing scandal unscathed. But somehow those climbing on board at that time thought there was reason to believe American was close to bear-market-proof. Its emphasis on dividends and earnings did wonders in the 2000-02 bear market, which hit technology and Internet names the hardest. But the next bear market hit large-value stocks hardest, and that's where many American funds can be found. It's silly to expect a $50 billion large-value fund to move out of large-value stocks just before they get clobbered. Yet American funds have seen huge redemptions since the 2007-09 bear market. Its funds were not great, but they didn’t embarrass themselves.

Let’s drill down to look at one particular fund from American Funds:  American Funds Investment Company of America (AIVSX) lost 34.7% in 2008 while the S&P lost 37%. So, what conclusion did investors draw? That active management was a crock and indexing was the way to go. The fund saw $6.0 billion exit in 2008 followed by $4.8 billion in 2009, $5.5 billion in 2010, $6.3 billion in 2011, $5.7 billion in 2012, and $4.8 billion in 2013.

Other value funds came under fire then, too. People were also angry at  Oakmark Select (OAKLX),  Oakmark (OAKMX), and  Dodge & Cox Stock (DODGX) for sizable losses in the 2007-09 downturn. Yet that grumbling is largely forgotten as both funds have roared back since then.

While plenty of investors stuck with American Funds’ domestic-equity funds, Fairholme Fund, Oakmark, and Dodge & Cox Stock and are happy they did, these experiences suggest some changes in choices of standard-bearer as well as proper expectations for actively managed funds.

​So, What Should We Demand of Funds?
Expecting a fund to beat an index every year is just silly, as is expecting an index fund to beat a good actively managed fund every year. Expecting a fund that has always been fully invested to suddenly go all into cash the day before a bear market starts is also silly. No fund, active or passive, will do that.

A stock fund should deliver superior risk-adjusted returns over a long period (say 10 years or more). That’s the case for active and passive funds. If a fund fails to do that or you think it can no longer do that, you should move on.

For a bond fund, we should demand strong risk-adjusted returns over a slightly shorter period than I suggest for stock funds, with an important caveat. Investors often hold bond funds as a long-term, strategic allocation for two different reasons: safety or income. Keeping in mind that credit cycles tend to last around seven years, bond funds built for downside protection often lag more-aggressive funds in risk- or yield-seeking environments. As we’ve had a five-year rally in lower-quality debt, we’d be setting ourselves up for heartache if we fired all the high-quality managers at this point. Conversely, the risk-adjusted returns for many credit-heavy funds are currently looking pretty good, but buying those chart-toppers right now and throwing caution to the wind might not feel so good in four or five years if the credit bubble pops. 

Rather than focus on the extreme performers, investors do better to look for funds that appear to have sustainable competitive advantages that will lead to strong long-term returns. But don’t expect perfection or a winning hand every year. Of the 40 actively managed U.S. equity funds with Morningstar Analyst Ratings of Gold, 38 suffered at least one year of bottom-quartile performance in the past 10 years.

Consider this graph of three funds: Oakmark Select, Fidelity Magellan, and  Vanguard 500 Index (VFINX). With hindsight, Oakmark Select’s slump in the middle looks like a mere blip, but it sent lots of investors running for the exits. Fidelity Magellan, on the other hand, gave investors good reason to bail on the fund. It lagged the index for quite a few years, and it had multiple manager changes and the same poor performance over the 10 years from 1996 to 2006.

What Should We Expect of Fund Investors?
To use actively managed funds well, you need to spend a little time getting to know the basics of the strategy. How is it run, and what are the parameters and risks? What kind of markets should it do well in, and how flexible is it? A little bit of homework will go a long way in identifying managers who stand a good chance of outperforming the market over the long haul.

For instance, a concentrated fund takes on a lot of issue-specific risk in a similar fashion to Warren Buffett. Even if management is right about its stocks, there will be years where a few top holdings get smacked and the fund looks like a dud. The idea is to be so choosy about your investments that you are actually making your portfolio safer in the long run at the cost of added volatility in the short run. However, that doesn’t make the strategy a bear-market lock.

Perhaps you want a fund that might actually dodge a bullet and move all to cash or slide from growth to value at just the right moment, but you should note that very few traditional domestic-stock funds even attempt that, so don’t expect it from them. But we have a group of funds that aim to do this: tactical-allocation funds. These funds shift among asset classes in order to boost returns and reduce risk. The catch is that asset-timing is very difficult, and even the best of them do just a little better than getting half their calls right.

Although every bear market is different, many equity funds do run to the cautious or aggressive side of their peers, so it is fair to assume which are more or less likely to hold up well in a down market. Just understand we're talking probability, not certainty.

Final Thoughts
Actively managed funds can be less risky or more risky than the market, but they can’t beat it every year. If you want instant results, stock funds probably aren’t for you, as markets are just too unpredictable. But if you accept these facts and maintain a long-term focus with your long-term assets, you’ll do just fine.

Our Morningstar Analyst Ratings are designed to guide you to the best long-term investments, and our record suggests that we do a decent job. A plan, doing some homework to select good funds, and patience will get you a long way. 

A version of this article was originally published in the October 2014 issue of Morningstar FundInvestor. Download a complimentary copy of FundInvestor here.

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