Mark Twain once allegedly said that the rumors of his death were greatly exaggerated. Well, I could argue the same about mutual funds and about active management altogether.
Mutual funds — particularly expensive actively-managed ones — have been losing market share to cheap index funds and to simpler and more tax-efficient exchange-traded funds (ETFs).
It’s pretty easy to understand why. Most “active” managers are really closet indexers that hug their benchmark index like a child’s security blanket. It’s hard to justify charging a high management fee if you’re essentially just tracking the S&P 500 but with less tax efficiency and cruddier performance.
And ETFs additionally have the advantage of being vastly simpler to buy for most investors. In order to buy a mutual fund, your broker has to have a selling agreement in place with the mutual fund company. Alternatively, you can contact the fund directly to invest, but that can be cumbersome if you want to own multiple funds run by multiple fund companies. ETFs, in contrast are available in any brokerage account with access to the New York Stock Exchange.
So again, it’s understandable why traditional mutual funds have been losing ground to index funds and to ETFs.
Yet before you write off mutual funds entirely, consider that there are still scenarios where they make sense.
Why Mutual Funds Are Still Relevant
To start, an active manager worth his salt will have a relatively low correlation to the major benchmarks like the S&P 500. They’ll zig when the market zags. So, a diversified portfolio that combines passive index funds and active traditional mutual funds should have lower overall volatility than one that uses only one or the other.
Furthermore, fully discretionary active management often doesn’t make sense in an ETF structure. ETFs are generally designed to track an index, and while a manager can build their own customized index to follow, that’s somewhat awkward and clumsy to implement.
Sure, actively managed ETFs exist and have thus far worked pretty well in the bond space. Both DoubleLine and Pimco have popular tactical bond ETFs in in the Pimco Total Return Bond ETF (NYSEARCA:BOND) and the DoubleLine Total Return Tactical ETF (NYSEARCA:TOTL). But these are the exception, not the rule.
So, with no further ado, let’s take a look at a couple of mutual funds that probably won’t get getting replaced by an ETF any time soon.
Fairholme Fund (FAIRX)
I’ll start with the Fairholme Fund (MUTF:FAIRX), managed by deep-value investor Bruce Berkowitz. Berkowitz is rare among mutual fund managers in that he tends to make large, high-conviction bets. His portfolio looks more like an activist investor’s hedge fund than a mutual fund designed for mom-and-pop investors. Around 70% of his portfolio is invested in just three stocks.
Berkowitz’s performance is a little erratic. He can be up big when the market is flat or down … or down big when the market is up. But that’s exactly what you want in an active manager. You want his portfolio to zig when the market zags.
And it’s worth noting that the performance isn’t shabby. Over the past 15 years, the Fairholme Fund has generated cumulative returns of 275% vs. 164% for the S&P 500.
Would I trust my entire retirement savings to Bruce Berkowitz? Obviously not. But would I consider his fund a very solid portfolio diversifier? You bet I would.
Fidelity Low-Priced Stock Fund (FLPSX)
As another example, consider Fidelity Low-Priced Stock Fund (MUTF:FLPSX), which is run by long-time manager Joel Tillinghast. Tillinghast has a quirky value investing style, and he limits his pool of potential stocks to those priced at less than $35 per share … a seemingly arbitrary number. But for Tillinghast, it seems to work. He has beaten his benchmark, the Russell 2000, over his career by about 4 percentage points per year, which is no small feat.
Now, I’ve obviously cherry picked two of my favorite managers here, and it would be ridiculous to suggest that they are “typical” of the industry. You’ve seen the stats: More than 80% of mutual fund managers underperform their benchmarks over time.
But if you’re looking for true diversification, you’re still more likely to find that with an active mutual fund manager than with the latest smart-beta ETF du jour.
Charles Sizemore is the principal of Sizemore Capital, a wealth management firm in Dallas, Texas.