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Actively managed funds catch up, a bit, to index funds

Traders work on the floor of the New York Stock Exchange (NYSE) on Sept. 6.

Brendan McDermid/Reuters

At last, a bit of redemption for the stock pickers.

Nearly half of all actively managed U.S. stock funds did better than a composite of index funds in the 12 months through June, according to Morningstar. Only about a quarter of those funds could make that claim at the end of 2016.

Active fund managers have become some of the most criticized, least popular investors on Wall Street. For most of the post-recession bull market, now in its ninth year, they delivered weaker returns than funds that passively track an index, while still charging higher fees.

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Managers say conditions are finally ripe for them to do better than index funds. Stocks are moving less often in herds, a departure from the years following the Great Recession. A scattered performance gives stock-picking managers more opportunities to differentiate themselves from index funds — assuming they choose the winners.

The Standard & Poor's 500 rose 15.5 per cent in the year through June 30, for example, but that masks some big differences in performance underneath. The best-performing sector of the 11 that make up the index, financials, jumped nearly 33 per cent over that time. The worst, telecoms, lost nearly 16 per cent. That gap of nearly 49 percentage points between the first- and last-place sectors compares with a gap of 28 percentage points at the end of last year.

"The waning lemming-like behaviour of stocks and sectors is boding well for active managers," says Liz Ann Sonders, chief investment strategist at Charles Schwab.

With the Federal Reserve pulling back on its stimulus, the expectation is that stocks will continue in their scattershot ways, rather than revert to herding. In the years following the financial crisis, the Fed's unprecedented amount of aid for the economy helped to lift markets broadly. But the central bank has raised short-term interest rates three times in the last year, and it's preparing to begin paring back the $4.5 trillion in Treasury bonds and other investments it's built up.

Fund managers have benefited in particular this year from their preference for tech stocks. Large-cap mutual funds keep about 26 per cent of their portfolios in the technology sector, according to a review by Goldman Sachs strategists. That's a higher percentage than the 22 per cent that the S&P 500 index has in tech.

Managers tend to keep more of their portfolios in Facebook and Alphabet stock than the S&P 500 does, for example, and both those stocks are among the market's better performers this year.

Even with their improved recent performance, stock pickers still have a long way to go to match the long-term returns of index funds. Consider the most popular category of mutual funds, ones that own a mix of large-cap U.S. stocks. Just 14 per cent of such actively managed funds have beaten index funds over the last decade, according to Morningstar.

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The success rate is a bit better in areas of the market where conventional wisdom says a skilled manager can make a bigger difference. But the odds of finding one that did better than an index fund are still worse than a coin flip. Out of the 12 fund categories that Morningstar studied, active managers as a group had the most success in intermediate-term bonds, where 44 per cent beat index funds over the last decade, and in emerging-market stocks, where 34 per cent did so.

That's why many market watchers expect index funds to remain popular. Of every $100 invested in U.S. mutual funds and ETFs, nearly $38 is in an index fund. That's up from just $3 in 1995. And it could grow to $50 in about five years, as investors continue to pull money out of actively managed funds and put it instead into index funds, and as long as there's no recession, says David Bianco, chief investment strategist at Deutsche Asset Management.

In the end, a fund's expenses may matter more than anything else. By allowing investors to keep more of their returns, low-fee funds have a built-in head start for returns.

It just so happens that one of the biggest advantages for index funds is that they have lower fees. Stock index funds kept $9 of every $10,000 invested in them last year to cover expenses, according to the Investment Company Institute. Funds run by stock pickers, meanwhile, kept $82.

Funds run by stock pickers likely can't match index funds' low fees. They have to pay the salaries for their teams of analysts, after all. But some funds charge less than others, and those tend to be the better performers.

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