Stock-picking fund managers are clawing back. Can it last?

Mutual fund managers are making the most of the shaky stock market, which has provided them an opportunity to prove themselves and lure back investors who dumped them in recent years.

Nearly half of all actively managed U.S. stock funds turned in better returns than their average index-fund peer for the 12 months through June, according to fund tracker Morningstar. Their success rate of 48% may not sound very impressive, but it’s much better than the 37% of a year earlier.

That supports the contention that stock-picking fund managers do their best work when markets are shaky because they’re free to avoid risky stocks dragging down the S&P 500 and other broad indexes. Index funds, on the other hand, mimic those indexes’ falls. These extra returns above index funds — what the industry calls “alpha” — are what managers hope will keep investors from panicking and selling their stock funds when prices fall.

“The unfortunate reality is that active managers tend to add alpha when the market is heading lower,” said Steven DeSanctis, equity strategist at Jefferies. And the market has been heading lower more often in the last year, often to only quickly jerk higher again, as investor fears about a possible recession wax and wane. The S&P 500 tumbled nearly 20% in late 2018, only to start 2019 with its best opening quarter in decades.

Some of the strongest gains in relative performance recently have come from managers of funds that focus on smaller and mid-sized stocks. They likely benefited by steering away from the smallest stocks, which have struggled much more than big stocks over the last year.

But experts caution that short-term performance figures can be erratic, and last year’s pickup in performance wasn’t enough to shift the long-term trend, which still shows most stock-picking managers failing to keep up with index funds.

“Over longer periods of time, active managers have had a hard time surviving,” said Ben Johnson, global director of passive strategies research at Morningstar. “The ones that die off tend to be funds that are not performing very well. But even among the remaining ones, what you see is many still fail to produce an outcome that investors might have gotten if they had just picked an average passive fund.”

Consider funds that invest in a mix of large-cap stocks, which are among the most popular investments and often benchmark themselves against the S&P 500. Just 8% of such actively managed funds beat their index-fund peers over the last decade.

The penalty for picking the wrong active fund is also often bigger than the potential reward. Over the last decade, more actively managed U.S. large-cap blend funds did at least 4 percentage points worse annually versus an index fund than did 1 percentage point or better.

Investors have paid close attention to such numbers. They’ve pulled hundreds of billions of dollars annually out of actively managed U.S. stock funds and plugged roughly the same amount into funds that simply and cheaply track the S&P 500 and other indexes.

Some areas of the market seem more conducive to active management than others. Among high-yield bond funds, for example, the majority of active managers have done better than index funds over the last decade. The same goes for funds that own a mix of small- and mid-cap foreign stocks.

Regardless, the best approach seems to be looking for funds with low expenses. While their rates of success may not always be better than a coin flip, they are nevertheless much higher than for more expensive funds.

“Pick your spots and focus on costs,” Morningstar’s Johnson suggested. “In fixed income and foreign stocks, you’re more likely to find a winner, especially if you focus on cheaper funds, and the shortcomings of picking a loser are less dramatic.”

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