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How to Use Actively Managed Funds

Passive investment strategies have become popular for good reasons. Index mutual funds and exchange-traded funds (ETFs) that track market benchmarks offer broad market exposure and tend to be much cheaper to own than funds actively managed by an investment professional.

But too often, investors overlook the unique potential of some actively managed funds, perhaps out of concern they’ll be too costly or end up underperforming a passive alternative. At times, active managers’ flexibility and specialized approaches to security selection can be an advantage, particularly when markets are turbulent. In fact, it might make sense for a truly diversified portfolio to include an allocation to both types of strategies.

“By holding a mix of passive and actively managed funds, you can take advantage of the strengths of the different approaches,” says Jim Peterson, chief investment officer of Charles Schwab Investment Advisory (CSIA).

Here we’ll look at a few of the potential advantages of active fund management and consider some strategies for selecting such funds.

Qualities to consider

Responsiveness to risk. Active funds might appeal in particular to investors concerned about suffering big losses in downturns. Whereas index mutual funds and ETFs will slide just as far as their benchmarks during a bear market, active managers work hard to manage risk by seizing certain market opportunities or using other techniques.

If this sounds good to you, you could begin your search for funds by identifying those with long track records of shining in hard times, keeping in mind that this doesn’t guarantee future success and that you should also consider other factors.

Understanding of foreign markets. Index mutual funds can be a good way to gain exposure to U.S. blue chip stocks, but because big, familiar companies are followed by thousands of analysts and professional investors, it can be hard for an active manager to gain an edge. In foreign stock markets, however, the game changes. Fewer institutional investors follow overseas shares, so it may be easier for fund managers to spot undiscovered gems.

Including different types of bonds. Active managers of fixed income funds have the potential to outperform their index counterparts in bond markets. For example, an index fund tracking the Barclays U.S. Aggregate Bond index would likely be heavily weighted toward Treasuries and other bonds backed by the U.S. government. At a time when Treasuries offer puny yields, active managers may be able to deliver better results by shopping for other securities.

“Active managers can potentially enhance returns because they have more flexibility to allocate to sectors such as corporate bonds and foreign bonds based on which sectors they expect to perform best,” says Jim. However, it’s also important to remember that higher yields typically come with higher risks.

Strategies for picking active funds

So what principles should you use when searching for an actively managed fund? Consider the following:

Look beyond short-term results. When investors shop for active funds, many pick managers who have delivered impressive short-term returns. But this can be a mistake. In some cases, the funds excelled by taking big risks or focusing on narrow segments of the market that can quickly move out of favor.

Be reasonable about cost. Some investors focus only on funds with the very lowest fees. While it is smart to avoid unreasonably expensive funds, fees should not be the only consideration. Instead, investors should look at a variety of factors. The goal should be to find managers who follow consistent strategies that have outperformed while limiting losses in downturns. A fund with low fees and an erratic record may not be as good a choice as a competitor with consistent outperformance and a slightly higher expense ratio.

Seek standout strategies. Portfolios that resemble their benchmarks are not likely to outdo the market, so look for funds with distinctive approaches. For example, managers could identify bargain-valued stocks that aren’t included in the benchmark index or they might venture outside the fund’s asset class: For example, a fund dedicated to large-cap stocks may be allowed to have up to 20% of its holdings in other assets.

Beware of bloated funds. Consider the size of the portfolio and whether investors have been pouring into the fund—these may not be good signs. For example, the most appealing small-cap funds tend to have less than $1 billion in assets. To appreciate why, consider a small-cap fund that has $200 million in assets and delivers strong returns. Investors pour in, and assets climb to more than $2 billion. To absorb all the cash, the manager may have to hold a greater number of stocks, picking names that are not necessarily his or her favorites. All that can result in weaker returns. “When a fund suddenly increases in size, its historical performance may not be sustainable,” says Jim.

As with any type of investment, not all actively managed funds are the same. Some are costly, some aren’t, and strategies vary.

What matters is whether you think a particular fund pursues a strategy that fits with your goals at a price you can accept. And think about how different funds might work with the other assets in your portfolio. It helps to think holistically about your investments. Don’t treat actively managed funds as a special category. They’re just one more tool to consider including in your toolbox.

Need helping picking funds?

Investors can consult Schwab’s Mutual Fund OneSource Select List®, which includes CSIA’s top picks in each category. The goal of CSIA’s approach is to identify funds that it thinks are most likely to outperform their peers over the next one to three years.

Spotting outperformers can be difficult, because some funds have lucky streaks that can make managers look more skillful. But hot funds often turn cold. To pinpoint attractive choices, CSIA researchers use qualitative and quantitative selection criteria such as expenses, historical track record and assets under management to analyze funds, with the most favorably evaluated ones earning spots at the top of the list.

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Important Disclosures

Investors should carefully consider information contained in the prospectus, including investment objectives, risks, charges and expenses. You can request a prospectus by visiting or calling Schwab at 800-435-4000. Please read the prospectus carefully before investing.

Past performance is no guarantee of future results.

Investment returns will fluctuate and are subject to market volatility, so that an investor's shares, when redeemed or sold, may be worth more or less than their original cost. All funds are subject to management fees and expenses.

Small-cap funds are subject to greater volatility than those in other asset categories.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk.

International investments are subject to additional risks such as currency fluctuation, geopolitical risk and the potential for illiquid markets. Investing in emerging markets may accentuate these risks.

Schwab Mutual Fund OneSource Select List® information is provided for general information purposes only and should not be considered an individualized recommendation or personalized investment advice. The securities listed may not be suitable for everyone. Each investor needs to review a security transaction for his or her own particular situation. Schwab or its employees may sometimes hold positions in the securities listed. Charles Schwab & Co. Inc. is the underwriter and distributor of Schwab Funds®.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float-adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the US & Canada. The MSCI EAFE Index consists of the following 21 developed market country indexes: Australia, Austria, Belgium, Denmark, Finland, France, Germany, Hong Kong, Ireland, Israel, Italy, Japan, the Netherlands, New Zealand, Norway, Portugal, Singapore, Spain, Sweden, Switzerland, and the United Kingdom.

The Barclays U.S. Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar-denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, MBS (agency fixed-rate and hybrid ARM pass-throughs), ABS and CMBS (agency and non-agency).

Charles Schwab Investment Advisory, Inc. (“CSIA”) is an affiliate of Charles Schwab & Co., Inc. (“Schwab”).


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