How to Identify Mutual Funds Most Likely to Outperform the Indexes

Identifying mutual fund managers who have outperformed the stock indexes in the past isn't hard. What's hard is identifying those who have the best chance to outperform in the next 10 and 20 years.

Identifying mutual fund managers who’ve outperformed the stock indexes in the past isn’t hard. What’s hard is identifying those who have the best chance to outperform in the next 10 and 20 years.

It can be done. Instead of just going on past performance and gut instinct, there’s a sounder way to identify the best active equity-fund managers. It involves selecting funds that are low-cost and have high portfolio manager ownership.

First, start with the cheapest funds. With most things, you get what you pay for. With actively managed mutual funds, the opposite is true. High-cost funds are worse, not better. They underperform because high fees cut eat into returns over the long term.

Toss out funds in the top 75% of expense ratios. Stick with ‘cheap’ funds—those with expense ratios in the lowest quartile.

Next, narrow down that universe by selecting funds whose portfolio managers put more of their own money into the funds they manage. Selecting funds both in the lowest-expense quartile and the highest quartile of manager ownership narrows down the field dramatically.

When American Funds ran the numbers last year, it found just 85 US equity funds and 20 international equity funds that fit both criteria. These funds have walloped the averages in the past—and we believe they have the best chance of outperforming in the future.

American Funds compared the performance of a portfolio of index ETFs versus selected active funds from 1994 through 2013 by creating a hypothetical portfolio. It had 25% in the S&P 500 and 25% in an international equity index, with the remaining 50% in various US asset classes.

That passive portfolio returned 5.69% annually over 20 years, from 1994 through 2013.

A portfolio composed of the 105 funds mentioned above, combining low cost and high manager ownership, returned 7.47% annually, 1.78 percentage points more: a 31.3% higher annual return compounded over 20 years.

A similar portfolio of core American Funds did even better: 8.17% annually, some 2.48% percentage points more a year more than the passive portfolio, or 43.6% more each year for 20 years.

Active management—in the right hands—can build wealth faster and more reliably than an index strategy. And while past results don’t guarantee future results, this methodology is the most convincing I’ve seen. Low costs are fairly obvious, but the beauty of high manager ownership is that these people are literally putting their money where their mouth is.

Frank Congemi is an investment advisor in Deerfield Beach, FL. Since it can be daunting for investors to screen thousands of mutual funds to identify those with low costs and high manager ownership, Congemi is launching a new website he calls “No Bull Street” that will offer a carefully curated set of low-cost funds with solid long-term records, all of which are open to investors with as little as $250 to start. He expects the site to be running in June. Until then, more information about him can be found at www.frankcongemi.com. He can be reached at 800-228-2309 or frank@frankcongemi.com.