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Picking Active Funds

YOU’VE HEARD ALL the arguments in favor of indexing—but you still want to try your hand at picking actively managed funds. What should you look for as you seek market-beating funds for each slot in your target portfolio?

  • You want fund managers with great performance over five years and preferably longer. If a mutual fund has notched market-beating returns but the manager responsible has since moved on, the record is meaningless.
  • You want managers with strong records relative to an appropriate benchmark index. If we’ve had a period when small-company growth stocks have sparkled, small-company growth-stock managers will have good absolute performance. But how do these managers compare to an index of small-company growth stocks?
  • You want to see consistency. If a manager has a great five-year record but it’s built on one spectacular year, you may be looking at a fluke performance. Be warned: Even if you identify managers with strong, consistent performance relative to their competitors, there’s no guarantee these managers will continue to shine. Instead, the goal here is more modest: You want to rule out managers who have proven themselves to be untalented.
  • You want annual expenses of less than 1%, and the lower, the better. An actively managed fund will charge more than an index fund. Still, if the expenses are too high, the manager will find it awfully tough to beat the market.
  • You should lean toward funds with lower portfolio turnover, preferably 40% or below. Like high expenses, high turnover means high costs—and it’ll be that much harder for the manager to beat the market. High turnover also usually means big annual taxable distributions.
  • You should favor smaller funds. If a fund’s dazzling record has attracted billions of new dollars from investors, the manager could struggle to invest the money involved and may be forced to buy less attractive investment ideas.

As you search for actively managed funds, be sure to spend some time on Morningstar.com, where you can find the data you need to analyze funds.

Next: Why Active Funds Falter

Previous Index Mutual Funds vs ETFs

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