What to Look For in an Actively Managed Fund

Many mutual fund owners are victims of the performance game that is played out day after day. A fund achieves good performance for some period of time, strongly advertises this performance, attracts new money, and subsequently turns in disappointing performances. Maybe the fund was in the right sector at the right time, as technology funds were in 1998 and 1999. Perhaps one of the investment styles was currently favored by investors, such as value investing or growth investing. Maybe the fund simply took more risk than other funds when the market was going up, and therefore it performed even better than the market.

It is indeed difficult to spot the strong performers and invest in time to benefit from that strong performance. Presumably, however, it can be, and is, done by at least some investors. Clearly some funds do turn in very good performance over multiple-year periods; just ask the owners of the Magellan Fund when Peter Lynch was the manager.

How can you go about spotting a winner? Although there are no guarantees, and most investors will be better off in the long run with an index fund, let's consider some characteristics that contribute to successful performance by a mutual fund.

As our example, we analyze the Ameristock Fund, founded in 1995. The trading symbol is AMSTX and minimum initial investment in this fund is $1,000.

This fund is designated a large value fund in terms of investment style, so we would expect it to hold large-cap stocks that are judged at the time of purchase to be undervalued. Although the names of the companies held are familiar, the manager claims that he buys these stocks when other investors are avoiding them.

First, the performance record: The fund has a Morningstar rating of five stars. Ameristock has outperformed the S&P 500 Index and its peer group of large-cap value funds. According to Morningstar data, for the five-year period ended mid-March 2002, the annualized return was 16.51 percent versus an annualized return of 6.98 percent for the S&P 500 Index, an annualized differential of almost seven percentage points. For the comparable three-year period, Ameristock had an annualized return of 7.73 percent compared to an annualized return on the S&P 500 Index of –2.51 percent, a differential of more than 10 percentage points on an annualized basis.

Meanwhile, its risk (as measured by beta) is only two thirds that of the market, that is, this fund is two thirds as volatile as the overall market.

Beta is a measure of a stock's or fund's volatility relative to that of the overall market, which has a beta of 1.0 by definition. Therefore, a beta less than 1.0 for a fund indicates that the fund's returns are less volatile than the market, whereas a beta greater than 1.0 would indicate the opposite. Morningstar reported a beta of .55 for Ameristock in mid-March 2002, and Mutual Funds Magazine reported a beta of .66 in its April 2002 issue. Such differences can arise based on differing time periods and slightly different methodologies used in calculating beta.

Consider now the following points about Ameristock that contribute to its success:

1. Manager tenure. The lead manager has been in place since 1995, when the fund was started. The average tenure of all mutual fund managers is four years.

2. Sales load. None.

3. Redemption fee. None.

4. Annual distribution fee. None.

5. Annual expense ratio. 0.77 percent.

Summarizing, this is a no-load fund, with no 12b-1 fee, and with a very favorable annual expense ratio compared to the average equity mutual fund.

6. Tax efficiency. 87 percent (three-year period).

7. Turnover rate. 15 percent (three-year period).

Ameristock has had a very low turnover rate for an equity mutual fund. This has contributed significantly to its tax efficiency, which benefits its shareholders. Also, the manager makes a conscious effort to sell losers to offset gains.

Clearly, Ameristock has performed well as an actively managed fund, outperforming the market and its peer group by a substantial margin while taking less risk than the market as a whole. It is a no-load fund with a very reasonable annual operating expense ratio. It has a high degree of tax efficiency, making it a good choice for shareholders using taxable accounts rather than tax-deferred accounts. If this fund can continue with this type of record, its shareholders should be very happy.

One of the likely reasons for its success to date is that the fund holds only about 50 stocks, compared to 500 stocks in the S&P 500 Index. Therefore, the winners have more of an effect on the portfolio's overall success. The opposite, of course, also applies. Losers will loom larger for Ameristock than for the S&P 500 Index because they will constitute a larger percentage of the overall portfolio. As long as the manager can continue to pick more winners than losers, the fund will succeed.