By Adam Zoll
Beating the index. It's what every active fund manager and active fund shareholder hopes to do. But studies show that, over the long haul, beating the index can be very difficult, especially in some fund categories.
Russel Kinnel, Morningstar's director of mutual fund research, wrote last year about the debate between active investing--in which managers choose specific securities in pursuing an overall strategy--and passive investing--in which funds simply track an index. Kinnel studied success ratios--that is, the percentage of surviving funds outperforming their category averages--within various asset classes for the five-year period ended Dec. 31, 2010. Among domestic-stock funds he found that 39% of surviving passive funds outperformed their category averages during that period versus 34% of active funds that did so.
In fact, a look at long-term performance of index funds versus their categories reinforces the notion that it's tough to beat the market over the long haul. For example, Vanguard 500 Index (VFINX), which tracks the large cap-dominated S&P 500, has outperformed more than two thirds of its large-blend peers on an annualized basis during the trailing five- and 10-year periods. Vanguard Mid Cap Index (VIMSX), which tracks the MSCI U.S. Mid-Cap 450 Index, has outperformed 59% and 75% of its mid-blend peers on an annualized basis during the trailing five- and 10-year periods, respectively.
For active funds, often-high expense ratios are one of the biggest impediments to beating their benchmarks. An active fund charging a 1% expense ratio must outperform its index by 1% just to keep pace. That's a high bar to clear, especially over the long haul, when consistent performance amid the inevitable ups and downs of the market can pose a real challenge. But difficult does not mean impossible, and there are those funds that manage to outperform the index even over long stretches.
During the next several weeks we'll use Morningstar's Premium Fund Screener tool to find funds that have beaten their indexes over the long haul. We'll look at funds in various categories, beginning this week with mid-caps, and later we'll examine large- and small-cap funds, international funds, and bond funds.
For this week's exercise we screened on all mid-cap funds (mid-growth, mid-value, and mid-blend) and compared their five- and 10-year annualized returns with the Russell Midcap Index, which is made up of about 800 securities with a median market cap of about $4 billion. The index returned 2.5% annually for the trailing five-year period ended Aug. 31 and 9.9% for the trailing 10-year period. By choosing both time frames we avoid funds that may have had good five-year stretches but did poorly the rest of the past decade. We also applied the distinct portfolio screen to weed out multiple share classes of the same fund and screened out index funds so that only actively managed funds remained.
The results: Out of 278 actively managed mid-cap funds in our database and with track records of at least a decade, only 15% beat the index in both time frames.
To identify actively managed mid-cap index beaters that might appeal to new investors, we screened on those funds with Morningstar Analyst Ratings of Bronze or better. We also added screens to weed out institutional funds and funds that are currently closed to new investors. The remaining list includes the following funds.
Fidelity Low-Priced Stock (FLPSX)
5-Year Annualized Return: 3.3% | 10-Year Annualized Return: 11.4%
Star fund manager Joel Tillinghast guides this very large ($35 billion in assets) mid-cap blend fund and has a superior long-term record, with 15% annualized gains (as of Jan. 31) since taking the helm in 1989. To keep the fund's giant asset base from driving up the share prices of companies it invests in, Tillinghast maintains a low-concentration portfolio of more than 900 holdings. The fund resides in the mid-cap blend category but invests about one fourth of assets in large caps, well above the category average of 16%. About 34% of assets are invested outside the United States, 10 times the category average. Tillinghast uses a value-oriented approach in seeking out companies with competitive advantages and trading at a discount to his estimate of their fair values. The fund also sticks with shares priced at $35 or less. Morningstar fund analyst Chris Davis lauds the tremendous research resources available here.
Baron Opportunity (BIOPX)
5-Year Annualized Return: 3.1% | 10-Year Annualized Return: 15.4%
In contrast to the giant Fidelity Low-Priced Stock, this small fund--with less than $400 million in assets--maintains a concentrated portfolio of roughly 60 names. Manager Michael Lippert, who took over the fund in 2006, has maintained its parent's approach, looking for growth-oriented businesses with competitive advantages and talented management teams. He also targets stocks priced low enough to potentially double within five years. Half of the fund's holdings are in technology (39%) or communications services (11%), both well above the category averages. One note of caution here: The fund carries an overall Morningstar Risk rating of high, suggesting potential downside volatility that is greater than that of its peers. Also, expenses are a hefty 1.41%, high for a no-load mid-cap fund.
Prudential Jennison Mid Cap Growth (PEEAX)
5-Year Annualized Return: 4.4% | 10-Year Annualized Return: 13.3%
Manager John Mullman, who took the helm of this load offering in 2005, seeks stable-growth companies with solid balance sheets. This fund has had one of the lowest downside capture ratios versus the Russell Mid Cap Growth Index of any of its peers under Mullman, meaning that it has weathered bear markets better than the competition. This emphasis on managing downside risk can cause it to underperform in up markets. Managers will hold onto stocks that grow beyond mid-cap range. As a result, the portfolio includes a 30% stake in large caps, well above the mid-cap growth category average of 18%.
Portfolio data for each fund shown as of the following dates: Fidelity Low-Priced Stock (April 30), Baron Opportunity (June 30), Prudential Jennison Mid Cap Growth (Aug. 31); all performance data as of Oct. 1.
Disclosure: Morningstar licenses its indexes to certain ETF and ETN providers, including BlackRock, Invesco, Merrill Lynch, Northern Trust, and Scottrade for use in exchange-traded funds and notes. These ETFs and ETNs are not sponsored, issued, or sold by Morningstar. Morningstar does not make any representation regarding the advisability of investing in ETFs or ETNs that are based on Morningstar indexes.