Can Anyone Find Index-Beating Mutual Funds? Maybe!

Roughly 95% of investors are either financially uneducated, or they believe they can find needles in haystacks. 

The financially uneducated ones give their money to financial advisors who typically invest their hard-earned money in actively managed mutual funds.  The investors may be rocket scientists, doctors, lawyers or ingenious academics, but most of those handing their hard-earned money over to a financial advisor tend to be financially naive.

The odds of paying somebody to choose funds that will beat a broad market index over time are miniscule, especially when accounting for the poorer tax efficiency that actively managed funds have over indexes.  Oh, and despite what their advisors tell them, they are paying those advisors—via load fees in, load fees out, trailer fees, soft dollar fees, or all of the above. 

But is it possible to find actively managed funds on your own that will beat the stock market indexes over the long term?  Maybe!

The average investor (buying actively managed funds) will trail a stock market index fund over the long term by roughly 2% to 3% a year, eventually earning a fraction of what they deserve.

Warren Buffett suggests that most individual investors (as well as most institutional investors) should stick to broad stock market index funds to maximize their success.

So is Buffett suggesting that investors can’t beat the stock market?  You might presume so.  But that’s not the case.  In his famous 1984 essay, “The Superinvestors of Graham and Doddsville”  he demonstrates that the market isn’t efficient, short term.  And well-trained, disciplined investors (with the right temperament) can beat the market.  Temperament, he suggests, is the key.  You can be the smartest person in the world, but if you aren’t “wired” to invest money, then no amount of academic learning is really going to help.  If you can control fear and greed, and you understand the fundamentals, then it’s possible:  you might be able to out-invest the market indexes.

It’s understandable then, that if you can’t beat the market yourself, you might want to find someone else who can invest on your behalf.  This is where market-beating mutual funds come in.  Buffett recommends indexes because of the high fees that most fund companies charge—not to mention their poor, after tax performance.  But does that mean that index-beating actively managed funds are impossible to find?  After all, there have to be mutual fund managers from the same genetic/academic vein as the “Superinvestors of Graham and Doddsville”, right?

If you twisted my arm and made me buy a slew of actively managed mutual funds, I know what I’d buy.  And for the most part, they’re fund companies that you haven’t heard of.  The top fund companies aren’t household names.  You generally don’t see them advertising themselves the way a well-known company like Fidelity advertises.  And they tend to pay financial advisors very little, if anything at all, so you won’t find them in most financial advisor-led accounts.

 Can you see the conflict of interest here?  Most advisors want to fill your investment account with funds that compensate themselves first, you second.

Great fund companies don’t tend to pay advisors generously (if at all), and they have some other things in common:

1.  They often shut their funds to new investors when they become too big.  Large fund assets make it hard to beat the market, so great fund companies shut their doors to new investors when their large funds balloon.  Companies like Fidelity and American Funds don’t bother doing this.  Assets under management mean money for the mother-ship, after all.  So if a particular fund attracts plenty of investors, it becomes a cash cow for the company, so why close their doors?

2.  They tend to charge low fees, and they have low taxable turnover.  In many cases, you must buy great mutual funds directly from the fund company, not through an advisor.  They keep fees low by keeping out the middleman, and they don’t “trade” a lot.  High trading volume means lower taxable efficiency.  For an actively managed fund to perform as well as an index fund after taxes, most have to beat the index by about 1% a year, just to break even.  And that’s really tough to do.

3.  They also tend to mandate that their managers invest large portions of their own net worth in their funds.  This also ensures that the managers are eating their own cooking.  They’ll want their money to do well, and they’ll want to do well after taxes.

4.  They are honest with their reporting.  On their websites, it’s always very easy to see what their fees are and what their returns have been relative to the stock market index.  They don’t just give you pieces of the truth; they give you the whole truth.  For every time period comparison (ie. How have they done over 1 year, 3 years, 5 years, 10 years, 15 years etc) they compare their funds’ results directly with the S&P 500 index—if it’s a large cap U.S. fund.  If it’s a small cap fund, they compare their performance to a small cap index.  It’s very admirable reporting.  Here’s an example

5.  Their funds have been around a long time.

So….which do I think the top mutual fund companies in the U.S. are?

In no particular order, here are a handful of companies deserving applause.  And they have all beaten the stock market indexes over the long term.  Funny though.  You may not have heard of them:

1.  Tweedy Browne

2.  Longleaf Partners

3.  Dodge and Cox

4.  Sequoia funds

5.  Royce Funds

There might be brilliant fund managers out there who can beat the market.  And this list of five fund companies may have a few of them in their midst. 

And if you’re going to venture off onto the road rarely taken (with these fund companies that are rarely, if ever, pushed by advisors) invest in them for the long run.  Most investors (and most advisors) jump around.  When their fund hasn’t done well lately, they switch to a fund that has.  I’m sorry if you think your advisor can do this and stay ahead of the curve—he or she can’t.

Stick with a great fund for the long haul and you’ll do far better.  And if anything, do the opposite of what most financial advisors would do:  buy mutual fund shares (in the above companies) after they have had a terrible year, relative to their peers.  Because they’ll likely come roaring back if they follow disciplined investment approaches.  And I believe that the above funds do.

If you want to know if your investment advisor is truly a fool, listen for these words:

“We’re going to get you out of this fund because it hasn’t done well lately.  And we’ll get you into this other one because it has.”

It doesn’t matter what those funds are.  A poor recent performance alone is a terrible reason to leave a mutual fund.  If your advisor lacks the sophistication to say something so silly—run from that advisor, and don’t look back.

Then buy and hold broad market indexes–or funds like the companies listed above.  Studies have shown that investors who trade more often (whether they’re mutual funds or individual stocks) perform far worse than investors who buy and hold.

Human instincts tempt most people to sell low and then buy high.  Buying yesterday’s recent winners is always a bad idea because they often turn into tomorrow’s losers.  And jumping around, instead of buying and holding, can have significant tax consequences as well.

But another word of caution:

Do you remember what I said about how an actively managed mutual fund (in a taxable account) will have to beat its counterpart index by roughly 1% a year, just to break even with the performance of the index?

One of the above companies, Tweedy Browne, actually shows its pre-tax and post-tax performance comparison with the S&P 500 index.

Since 1993, its value fund has amazingly beaten the S&P 500 before taxes.  As you can see below, it has produced an annual return of 8.53% before taxes, versus 7.59% for the S&P 500 index.  But that’s before taxes.  Tweedy Browne is fabulous enough (I love honest companies) to show its annual return after taxes and distributions.  Compared to the index (which is more tax efficient than an actively managed fund) the comparison doesn’t look as stellar for this fund now, as you can see below.

Annual Total Returns For Periods Ending 12/31/09 (%)


Tweedy, Browne Value Fund


Average Annual Total Returns

Return Before Taxes

Return After Taxes on Distributions

Return After Taxes on Distributions & Sale of Fund Shares

S&P 5002

 

Morningstar Average
Domestic Stock4

1 Year

 27.60

 27.39

 18.23

 26.47


 30.90

3 Years

 -0.98

 -2.20

 -0.94

 -5.61

     –

 -4.20

5 Years

  2.08

  0.82

  1.71

  0.42

     –

  1.27

10 Years

  3.82

  2.83

  3.12

 -0.95

     –

  1.88

15 Years

  9.24

  8.26

  8.03

  8.03

     –

  7.77

Since Inception (12/08/93)1

  8.53

  7.60

  7.39

  7.59

     –

  6.92

 But Tweedy Browne is still a fabulous actively managed fund company.  And if you twisted my arm and made me buy some actively managed funds, this would definitely be one of them.

That said, tread lightly into this good night.  Finding outperforming actively managed funds ahead of time can be a tough thing to do—as the past isn’t always a prologue to the future.  You’ll be relying on long odds, and if you want to beat a comparable index after taxes, your funds will have to beat the market by more than 1% a year.

Impossible?  Nope.  You might be able to do it.  It’s just not a wager I’d be willing to bet.





Andrew Hallam

I’m a financial columnist for Canada’s national paper, The Globe and Mail, as well as for AssetBuilder, a financial service firm based in Texas. I’m also the author of Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School (2nd Ed. Wiley 2017) and The Global Expatriate’s Guide To Investing: From Millionaire Teacher to Millionaire Expat (Wiley 2015). My mission is to educate, motivate and inspire people on basic retirement planning and best practices for investing, using evidence-based strategies. I’m happy to comment on your questions. However, please read the Terms of Use, Privacy Policy and the Comments Policy.

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