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strategy lab

Norman Rothery is the value investor for Globe Investor's Strategy Lab. Follow his contributions here and view his model portfolio here.

There is a myth going around that most fund managers are bad stock pickers. It is undoubtedly true that some are, but it turns out that most beat their benchmarks over the long term.

That's just one of the interesting findings Dr. Antti Petajisto presented in his paper Active Share and Mutual Fund Performance, which appeared this summer in the Financial Analysts Journal.

He focused on domestic stock funds in the United States and measured how well they did in comparison to their benchmark indexes.

Fund managers outperformed their benchmarks by an average of 0.96 per cent a year from January, 1990, to December, 2009. That might not sound like a huge performance boost, but it does compound nicely over time.

It also demonstrates that employing a little intelligence when picking stocks can be quite profitable. Make no mistake, it's a fruitful endeavour, no matter what some strident index-investing proponents might suggest.

On the other hand, Dr. Petajisto's paper also reinforces the notion that costs matter. Sure, the fund managers bested their benchmarks by nearly one percentage point annually. But investors only benefit if they pay less than that on average.

Alas, once fees were taken into account, the average mutual fund in the United States lagged its benchmark by 0.41 per cent a year over the 20-year span.

In other words, those thrifty index investors have a point.

Similar findings have convinced many people to give up on actively managed funds entirely. Instead they focus on low-fee passive investing and it's a move I have some sympathy for.

But it's also worth highlighting another aspect of Dr. Petajisto's study.

He took a careful look at something called "active share," which is a measure of how closely a fund resembles its benchmark.

Funds with high active share have portfolios that don't look like their benchmark indexes. Those with low active share have portfolios that look very much like the market and can be described as closet index funds.

Problem is, according to Dr. Petajisto, the majority of U.S. funds are closet index funds or merely moderately active. Investors in these funds tend to get index-like returns before fees but they materially underperform after fees. Given the prevalence of such funds, it's little wonder why active funds have such a poor reputation.

However, diversified funds with high active share – a category Dr. Petajisto calls stock pickers – did much better. The stock pickers beat their benchmarks by an average of 2.61 percentage points a year over the two decades before fees. They outperformed by 1.26 percentage points after fees.

He also considered a few other categories of funds even though they all trailed their benchmarks after fees. Of the bunch, concentrated funds fared the best. Such funds have high active share but own a small number of stocks, which leads to a poor level of diversification.

The concentrated funds trailed their benchmarks by 0.25 percentage points annually over the two decades after fees. It was a near miss, but still a miss. The category was likely hurt by fund managers who were willing to take big risks to establish a good performance record in an effort to attract more assets. In any event, concentration was not the way to go on the whole.

If you're fond of active management, the lesson is clear. You should gravitate to funds with reasonably diversified high-active-share portfolios managed by stock pickers. You should also be able to improve your odds by opting for managers who don't charge an arm and a leg for their services.

But there is no need to be dogmatic. A thrifty portfolio that combines both passive and active funds might be just the thing. Start with a broad core of frugal index funds and supplement it with a few low-fee active funds run by good stock pickers. With a bit of luck, you'll get the best of both worlds.