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Improve Your Active Fund Strategy

If you’re choosing between active and passive investment approaches, passive has a lot going for it. Index mutual funds and exchange-traded funds (ETFs) that track market benchmarks tend to be much cheaper to own than actively managed mutual funds. ETFs, in particular, have seen their popularity soar, zooming from $891 billion in assets in 2010 to $1.7 trillion today, according to the Investment Company Institute, a fund trade group. And it turns out that passive funds’ more modest goal—to deliver returns in line with the market—usually outdoes active funds’ attempts to provide market-beating performance.


Improve Your Active Fund Strategy 2

Still, that doesn’t mean you should abandon funds that adhere to an active strategy. If you can seek out funds that have a chance to deliver a benefit, their extra cost may be worth it. And while most active funds won’t give you bigger gains than ETFs or index funds in all parts of the market, active managers’ flexibility and strengths in certain areas may yet give you an advantage. Active funds can sometimes be particularly helpful in defending your portfolio when things get turbulent. 

In fact, to build a diversified portfolio, you might want to own both active and index funds. “By holding a mix of funds, you can take advantage of the strengths of the different approaches,” says Jim Peterson, chief investment officer of Charles Schwab Investment Advisory (CSIA).

What should investors look for now?

Access to foreign markets. Index mutual funds can be especially appealing for exposure to U.S. blue chips, but because the 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’s easier for fund managers to spot undiscovered gems. During the past three years, the average actively managed foreign large-blend mutual fund returned 5.6% annually, outdoing the MSCI EAFE index by one percentage point, according to Morningstar (the data doesn’t include ETFs). Managers may have obtained these results by spotting opportunities such as small-cap stocks, for example.

A wider range of bonds. Active managers can also fare well in bond markets. Typical bond index funds track the Barclays U.S. Aggregate Bond index, which has most of its assets in 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; however, higher yields typically come with higher risks. “We think many managers have increased returns by emphasizing corporate and foreign bonds,” says Jim.

By holding a mix of funds, you can take advantage of the strengths of the different approaches.

Sensitivity to risk. No matter what their focus, active funds can be attractive for investors who worry about suffering big losses in downturns. Whereas index mutual funds and ETFs will slide just as far as their benchmarks during a bear market, some veteran active managers work hard to manage risk by seizing certain market opportunities or using other techniques. Similarly, you can look for funds that have long track records of shining in hard times, keeping in mind that this doesn’t guarantee future success. 

How do you find active funds that may boost returns while limiting your portfolio’s risk exposure? 

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 take only the 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 large cap fund is allowed to have 20% of its holdings in assets that aren’t large cap.

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 blistering 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 historic performance may not be sustainable,” says Jim.

What do you do if you don’t have a lot of time for research?

Finding solid funds takes effort. Investors who don’t have time for research can consult Schwab’s Mutual Fund OneSource Select List®, which includes the Charles Schwab Investment Advisory's top picks in each category. CSIA screens all candidates thoroughly, looking to find the few managers they believe can deliver reliable returns over the long term. 

Spotting outperformers can be difficult, because some funds have lucky streaks when managers appear to be skillful. But often such hot funds turn cold. To pinpoint attractive choices, CSIA researchers use qualitative and quantitative selection criteria such as expenses, tracking error, 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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