Finding the Funds That Beat the S&P 500

I take the much easier route … investing in Vanguard’s S&P 500 index fund.

One criteria that should be included is length of tenure of the fund manager. If the 5 and 10 year performance is due to another fund manager, then it may not get the same performance going forward. I would posit that manager tenure is at least as important as Morningstar category and asset size.

Picking funds with terrible recent history isn’t that far off. Reversion to mean is a common occurence — today’s losers often become tomorrow’s winners and vice versa. Now the problem is deciding whether today’s losers are down because their style is out of favor, they’re unlucky or they’re just crappy managers. It’s impossible to tell until after the fact so for this type of scheme, I’d stick with broad indexes and pick the sectors/classes/sizes/tyles that have done the worse. For example, this year REIT and Small Cap Value are down and probably will continue to go down for some time until the housing/mortgage fallout is over. So I’d begin a multi-year DCA into REIT/SCV using money from sectors that have been booming lately (e.g. International, EM, TIPS).

There’s a downside to funds with lots of assets - if you’re counting on the manager to pick undervalued stocks they’ll only have a limited number of opportunities, and more assets means they have to either hold lots of cash or choose weaker stocks, bringing down the average returns.

To the person who recommends looking for funds with bad performance: past successes don’t mean there will be future successes, but past failures are an even worse indicator - especially with the recent gains. What you want are funds managed by people who have had past successes, but are well-priced now.

A good example of a successful fund is given in the book Unconventional Success: the fund in question has a 10-year record of beating the S&P 500 by 4% with the same managers, but has slow years; in particular, the book mentions a lot of investors leaving it when it underperformed the internet bubble (earning a poor Morningstar rating). It’s also closed to new investments on and off, since there’s only so companies that meet the managers’ criteria. In addition, the managers and many employees of the management company (as well as their families) invest in the fund - so good performance is more than a way to gain assets and fees. It has reduced the expense ratio in the past. You’ve thought of some of these requirements, but if it’s possible to add more factors to the morningstart search it might help refine the list.

In the mutual fund world it can be hard to figure out who’s really trying to give investors bigger returns without additional risk and who’s just trying to track an index and collect fees for “picking the right stocks”. I hadn’t thought of using a method like this to find the few truly superior funds, but it’s an interesting idea.

If you do find a good fund, it might have slow years when a regular index is doing well, so balancing it with other assets could still help.

I recently read “Rational Investing in Irrational Times” by Larry E. Swedroe and his other books. In his outspoken books, Mr. Swedroe virtually destroys mutual funds credibility in favor of index funds.
Another interesting book I am reading is by Patrick W. Rice “IRA Wealth, Revolutionary IRA Strategies for Real Estate Investment.”
At this point I am not sure what I am going to do with my IRA funds which are invested in mutual funds!
If anyone wants to review those two books, it would be great.

There is an easy way to test this theory. Go back 5 years, and find the funds that outperformed for the preceeding 10 years. Then see if they still outperform today.

I select based on expense ratio, duration and experience or management team, what they are invested in (international focus works best for now) and past performance compared to peers. Vanguard normally works best for me.

Andy