3 Active Funds That Complement the S&P 500

An S&P 500 Index fund is one of the classic portfolio building blocks. In a single low-cost package, you gain exposure to a broad swath of the U.S. market, as well as plenty of indirect exposure to foreign markets via the blue-chip multinationals that dominate the index. Given all of that diversification, as well as the fact that S&P 500 Index funds have been formidable foes for most active large-cap managers over time, it's no wonder that S&P 500 Index funds are such popular options on 401(k) menus. 

But the S&P 500 doesn't provide exposure to the entire U.S. market. It's missing small-cap exposure, and it's also light on mid-cap exposure relative to a total stock market index fund. Thus, the classic "completer" holding for a portfolio dominated by the S&P 500 is an extended-markets index fund like  Vanguard Extended Markets Index (VEXMX) or  Fidelity Spartan Extended Markets Index . These funds fill in any of the nooks and crannies of the U.S. market that the S&P 500 doesn't cover, and do so at a very low cost. 

Alternatively, investors could look to some sort of an active fund to complement a core position in the S&P 500. But if they do, they'll want to be careful that they're not buying a fund that overlaps significantly with the index, both in terms of its portfolio or its performance pattern.

Active share (not available on Morningstar.com) helps measure a fund portfolio's similarity with an index; funds with high active share have extremely differentiated portfolios relative to a given benchmark, whereas low active-share funds are more likely to be duplicative. Meanwhile, R-squared measures how closely an investment's performance has tracked a benchmark's. Funds that have shadowed an index's performance--at least directionally--receive high R-squareds relative to that index, whereas those with a differing performance pattern have lower R-squareds. 

To home in on the latter--funds with low R-squareds that might serve as reasonable complements to an S&P 500 Index fund--we turned to our Premium Fund Screener. We searched for still-open Morningstar Medalist domestic-equity funds with R-squareds of 50 or below with the S&P 500 over the past three years. The S&P has performed very well over this stretch, whereas all three of the offerings that made it through the screen have performed abysmally of late. That said, they should prove their mettle as diversifiers. Premium Members can click  here to view the screen or make adjustments to it. 

Here's an overview of the three funds that made the cut. 

 Conestoga Small Cap (CCASX)
Category: Small Growth | Analyst Rating: Silver
With a portfolio that's heavily concentrated in true small-cap growth stocks and a big emphasis on the technology sector--more than 40% of assets as of its Nov. 30 portfolio--it's no wonder that this fund's performance has diverged significantly from the S&P's. Historically, the fund had tended to lag in big rallies but made up ground in down markets; however, its results in 2013 and 2014 run counter to that pattern. Its many tech names contributed to a nearly 50% gain in 2013--well ahead of both the broad market and its small-growth peers--but that emphasis has contributed to an above-average loss so far this year. Senior analyst Janet Yang points to several positive fundamental aspects of the fund, however, including low turnover; an emphasis on high-quality, low-debt businesses; and reasonable fees. While the fund isn't exactly a hidden gem, its size shouldn't impede future results either. 

 GoodHaven (GOODX)
Category: Mid-Cap Blend | Analyst Rating: Bronze
This fund's contrarian-minded managers prefer deeply unloved names. Such stocks won't turn around overnight--and could drop further still, as the fund's 2014 losses attest. Indeed, senior analyst Kevin McDevitt says worst--or first--relative return rankings will most likely be the norm here. Managers Keith Trauner and Larry Pitkowsky run a concentrated portfolio--24 holdings currently--and will let assets build in cash and bonds if they can't find enough companies to buy at the right price. Results since the fund's mid-2011 launch have been underwhelming, but McDevitt points to the fund's pedigree as a key reason to give this fund a look: Trauner and Pitkowsky both worked on  Fairholme (FAIRX) when it put up some of its strongest performances, from 1999 through 2008. Investors must share management's long-term mindset if their investment is to pay off. 

 Fairholme (FAIRX)
Category: Large Value | Analyst Rating: Silver
While the aforementioned funds have all emphasized small- and/or mid-cap stocks, this is the only large-cap medalist fund to show up on our list of offerings with very low three-year correlations with the S&P. The fund's idiosyncratic performance path is a natural outgrowth of its extremely concentrated portfolio. With just 10 stocks in the portfolio, most of them deeply unloved, and a heavy emphasis on the financials sector, the fund's performance is much more influenced by its top positions than it is the broad market's movements. With its worst-to-first (and back again) performance pattern, Fairholme requires patience--something that many of its shareholders have not shown. Despite phenomenal, market-beating returns since its inception nearly 15 years ago, investors have undermined their results by buying and selling at inopportune times.