Mutual Funds that Beat the Market for Over a Decade


NEW YORK (MainStreet) — Passive investing is all the rage now that retail investors are giving up on trying to beat The Street. But the move away from trading and actively managed funds doesn't mean all funds are trailing the market. In fact, several are still beating the S&P 500 on a long-term time horizon, and some financial advisors are urging their customers to develop a more active investment strategy.

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2013 was a great year for passive investors in the stock market. While the Hedge Fund Equity Hedge Index saw 11.14% gains in 2013, the S&P 500 returned more than 30% to investors, urging many Bogleheads to crow that active management is dead and indexing is king.

More crucially, the massive underperformance of active investors has led a number of people to pull money from active money managers, both in hedge funds and in the retail mutual fund world. At the same time, low-cost, passive-managed ETFs have seen capital inflows reach all-time high levels.

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This doesn't mean that all mutual funds are losers, especially considering a longer-term time horizon. For instance, the Gabelli Asset Fund Class AAA mutual fund (GABAX) has returned 10.42% annualized over the past decade, compared to 8.4% for the S&P 500. Even the biggest proponent of passive investing is beating the market with an active fund: Vanguard, whose founder John Bogle is famous for beginning the passive investing revolution, offers a mutual fund that has beaten the S&P 500 over the past decade. Vanguard's Admiral Shares (VTSAX) is up 8.6% annualized over the last 10 years, and its alpha has grown considerably since the middle of 2010.

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Can the Strong Performance Continue?

Although some mutual funds have beaten the overall S&P 500, many are skeptical that the strong performance will continue.

"A lot of times it's just luck—if there are 10k or so mutual funds, there will be some that do better," said Craig Birk of Personal Capital. "We think that there probably are a small number of managers who have skill and can add value, but we don't think there's any way for the average investor to identify who those people may be."

Birk believes that active management has more been a game of luck than skill, and these mutual funds may see their luck run out soon.

"I don't think it's getting easier or harder to beat the market—fees and trading costs are very slowly coming down which may make it a little bit easier," Brik said. "About 60% of active funds are lagging the S&P every year. So we don't see anything that's making it easier or harder."

Many financial experts who disagree with Birk point to the very long track records of some funds that are more likely the result of skill than random chance. Certified Financial Planner Geoffrey Kanner says that greater access to data, global markets and asset classes can make a diversified portfolio outperform if it's managed well.

"If we're looking at the SPY index fund, clearly there are times when it does great and there are times when foreign investments will be great. With this, the average investor can buy 500 great companies in the U.S," Kanner says. "But when you take a look at the revenue—40% of rev comes from overseas. We're in a global market now. Same is true for the bond market. To understand this more complicated market, you need a sophisticated plan and understanding of the market."

Not All Indexes are Made Alike

Some ETF companies are trying to appeal to passive investors with smarter indexes that are designed for passive investment while beating the market. For instance, WisdomTree has courted retail investors with a variety of indices designed to offer exposure to various assets, and they have seen tremendous inflows into these so-called smart beta ETFs. "In 2013, we saw one-third of inflows ($60 billion of $180 billion) flow into alternatively weighted ETFs—smart beta ETFs," says WisdomTree Chief Investment strategist Luciano Siracusano. "I think that's a good signal, because that says investors are understanding there's a third choice between actively managed mutual funds and traditional low-fee index ETFs."

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Both the traditional low-fee indexes and the newer indexes designed by firms like WisdomTree are attracting a greater share of retail capital. Some advisors think this approach is often driven by a hunt for returns, but many investors fail to assess the risk associated with a long-only portfolio of index funds.

"When I compare a portfolio or an individual fund to the S&P 500, I will use Sharpe ratios, alpha, beta, etc. That's the only way to know if we are being compensated for taking that extra risk," Kanner says. "By the same token, if a fund has underperformed, that may be perfectly acceptable if we realize we have 30% or 50% less risk than the market. Many retail investors don't understand this."

--Written by Michael Foster for MainStreet

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