28 October 2020

How to Pick a Stock Picker

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For mutual-fund investors, the less-expensive choice is often the better bet. That rule of thumb has helped drive the rise of passive funds, which are designed to track indexes and generally charge lower fees than funds that try to beat a stock-market benchmark. Since the returns of funds that follow the same index should be similar, price is a major consideration. Yet the rule also applies when choosing among similar actively managed funds, experts say. Here is how to be smart about choosing an active fund:

The Low-Cost Case 

It is important to understand exactly why costs are crucial. The returns of active funds vary considerably—some do better and some do worse than their benchmarks. Whether the managers win or lose, they still charge often substantial fees.

One reason: Active funds have to hire analysts and data-crunchers to help determine which stocks to buy or sell, and when—expenses for which an index fund has no need since it typically holds almost every stock in the index. The problem, from an investor’s perspective, is identifying the active managers whose returns might justify their fees, particularly if the fund comes with a sales charge, or “load.”

Many funds that outperform over a short period struggle to repeat the feat in the long run. Figuring out which manager got lucky and which manager has skill is tough. As a result, lower costs generally put investors in a stronger position to log higher total returns, which include price changes and dividends.

It’s Complicated 

It isn’t difficult to find active funds that outperform less-expensive funds that buy similar kinds of stocks. At the same time, active funds that are less expensive often outperform similar rivals by a significant margin.

For example, the $1.1 billion Homestead Small-Company Stock Fund, run by Homestead Funds, in Arlington, Va., has generated average annual returns of 17.9% over the past five years and 11.6% over the past 10 years, through Thursday, according to Morningstar. The fund charges annual fees of 0.89%, which Morningstar categorizes as “low.”

What You Pay For 

Given those kinds of differences, it isn’t a surprise that experts see cost as just one of several factors to consider when choosing among active funds.

There are some other issues to think about, as well, experts say. First, make sure you are comparing similar funds by, for example, looking at their holdings and their investment philosophy. You also may want to consider how active an active manager is, by looking at how closely the fund’s holdings mimic its benchmark index and by comparing the fund to a similar rival. The comparison may not tell you much about which fund will do better. But it will give you some sense of what each manager is doing in exchange for the fund fee.

Look for fund companies that have expertise in the kind of fund that you are interested in and a commitment to keeping costs down, whether that is by keeping the expense ratio relatively low or by minimizing trading costs by avoiding excessive trading. Keep in mind that the expense ratio also can go down over time, particularly if a fund’s assets grow and its costs can be more widely spread.

The Role of Returns 

Investors often obsess about returns, and performance is worth looking at—though it has little or no predictive power. Study a fund’s returns both annually and over time, and see whether the fund has delivered consistently solid returns or whether it has outperformed wildly in some years and brought up the rear in others.

Similarly, check to see if a fund has a strong long-term record but has stumbled in recent years. That could be a warning sign, particularly if rival funds are thriving. Funds that grow too large can have difficulty replicating earlier success, particularly in certain parts of the market, such as small and midsize companies.

Click here to access the full article on The Wall Street Journal. 

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