The Uncomfortable Truth About Actively Managed Mutual Funds

The Uncomfortable Truth About Actively Managed Mutual Funds

The Best Active Manager is YOU!

A High-Flying Mexican Stock

The Uncomfortable Truth About Actively Managed Mutual Funds

For many investors, even the intelligent and well-informed readers of Cabot Wealth Advisory, the biggest decision to be made in their portfolio is whether to put your money into index funds or to make the jump to actively managed funds.

Yes, active management is a bit more expensive (in terms of management fees), but if you want to achieve that ultimate goal of the ambitious investor—beating the index!—you have to pay for the privilege.

But do you know what you actually get if you select an actively managed mutual fund? Do you have any idea how “active” the management really is?

Let me tell you.

Actively managed funds are always structured to include a benchmark, an index that is used to gauge the success of the fund for the quarter, the year, and five- and 10-year periods. Beating the index consistently seems like it ought to be the fund manager’s ticket to success, but there’s a hidden agenda at work: Nobody wants to beat the index by too much.

That’s because the successful manager actually has two goals. The most obvious one is to beat the index. But the second is to outperform all the other managers in his assigned class, whether it’s large-cap growth stocks or small-cap value issues. And that outperformance will make a manager’s fund attractive to investing whales like pension funds. And that’s where the real money is.

Finishing in the bottom half of your peer group isn’t a good thing, of course. But ending a year with performance in the top quarter of your peers is also suspect. In order to rank in the top quartile, you have to take on too much risk, which raises the spectre of finishing in the bottom quartile next year. (That’s really how the mutual fund industry thinks. I swear.)

Any manager who can bring his fund in with second-quartile performance year after year, will soon be looking for a bigger boat or wearing a rarer wristwatch.

But what about the poor individual investor who’s paying the extra bucks to beat the index?

That investor’s needs finish far behind the manager’s need to calibrate his performance to hit the sweet spot against all those other funds in his group. Even performance versus the index, which is supposedly what active management is all about, is less important to the institutional investors who have billions to allocate.

Believe me, if a fund manager can beat his peer group, his actual outperformance of the index is just an afterthought.

So, how does a manager contrive to outdistance his competitors by a decent—but not excessive—amount?

The first thing he does is to set up a portfolio that mirrors the relevant index, stock by stock and weight by weight. That’s why a stock that gets added to an index will often experience a surge in buying as managers who use that index as a benchmark adjust their holdings to match its weight in the index.

And then the tweaking begins. Maybe a manager’s research points to a slight decline in desktop computer sales during the next year. So he shaves off a small portion of his exposure (relative to the benchmark) to a parts supplier or a retail outlet that sells desktops. Or maybe a visit to a railroad company shows such a successful outlook for haulage that the manager returns to his headquarters and buys a bit more of a supplier of train cars until he has a slightly overweight position.

And in exceptional cases, the manager may even decide not to own a stock or two in the index or to buy a company that’s not in the index. Bold moves indeed!

Remember, however, that the manager isn’t trying to maximize gains! He’s shooting for outperforming half of his peer group and underperforming a quarter of them.

So when anyone asks me whether it’s worth it to diversify their portfolios using actively managed mutual funds, all I want to say is, “If that’s the most ambitious move you can think of, I think you’re selling yourself (and your portfolio) way too short. “

You don’t have to swing for the fences to knock in a heck of a lot more runs than any actively managed portfolio. With one foot tied to an index and one eye constantly watching what peer funds are up to, active managers are not out to make you real money. In fact, they can lose money and be quite proud of themselves if they have reached their twin goals: 1) Beat index. 2) Beat rivals (but not by too much).

Cabot growth advisories don’t give much of a rip about performance versus an index. The only use we make of indexes is to tell us when the trend of the market is up (in which case we move aggressively to identify and invest in the leaders) and when the trend is down (when we cut back on buying and move more cash toward the sidelines).

The person who cares the most about the absolute performance of your portfolio is you. And Cabot has almost 45 years of advising individuals like you about what stocks to buy, when to sell and how to get in sync with what the market’s doing.

If you want active management of your portfolio, Cabot can be the active partner you need to target real gains.

A High-Flying Mexican Stock 

With most Chinese stocks under heavy pressure from the general downtrend of the Chinese market, my stock pick today is a Mexican airline that’s prospering as more and more local travelers opt for the comfort of air travel over the vagaries of buses or trains.

The company is Volaris (VLRS), and while it’s a thinly traded issue (averaging around 235,000 shares traded per day), it’s also a bargain stock from a growing economic zone. VLRS trades at an attractive 12 P/E ratio.

Volaris is a low-cost airline that appeals to passengers visiting friends and family and to cost-conscious business and vacation travelers. The company’s 230 daily flights connect 39 destinations in Mexico, 22 cities in the U.S. and selected points in Central America. Its fleet of 53 Airbus aircraft is the youngest in Mexico.

There are plenty of attractive stocks outside of China for investors who are interested in taking on a little more volatility. Cabot China & Emerging Markets Report has been responding to the Chinese stock market crisis by moving steadily toward a heavier cash position; the portfolio is now 50% in cash, giving us plenty of protection from the unpredictability of China.

We will continue to look for the strongest stocks in the emerging world while adjusting our exposure as necessary to avoid their volatility.

And when China comes back—and you know it will!—we will be waiting with our cache of cash and our well-stocked watch list. It will be a fun time!  Click here to order.

Sincerely,

Paul Goodwin,

Chief Analyst,

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