[Editor's Note: This is a lengthy guest post by a long-time reader who would like to remain anonymous. I have included a lengthy comment at the end and wrote on a similar topic a few days ago. We have no financial relationship.]

What do you do if you love your job but are stuck with a lousy 401(k)? Perhaps the 401(k) has high expense ratios, no decent index fund options, and a poor selection of funds. Perhaps your employer provides you with a full match, so you definitely want to participate, but the plan doesn't allow inservice rollovers and the employer is not willing to improve the plan. You are stuck with this plan, for better or for worse, and need to figure out the best way to use it. This is the situation I found my wife to be in with her 401k.

Looking at the investment options, I saw a few high-expense ratio (0.65-0.87%) index funds offered by the plan provider in the US small cap, mid cap, and large cap categories, but no index funds in the international stock category, the emerging markets category, or the bond category. So to follow WCI’s advice to use only index funds, I could try to weight her IRAs and taxable accounts heavier into the categories without index options. However, I personally find this unappealing because most 401(k)s offer auto­rebalancing, and weighting asset allocations across different accounts can be tedious. So I am “forced” to look at actively managed funds to accomplish my goals with this 401k.

However, unlike WCI, I am agnostic when it comes to active versus passive management. I happen to apply passive strategies in 50% of my portfolio and active strategies in the other 50% of my portfolio. I do agree with WCI, that for most people, passive strategies are best because they are effortless, whereas with active management, one must spend time doing some research, and also have the perseverance and good investor behavior to stick with the actively managed strategy that you picked when periods of relative underperformance occur, because inevitably they will.

With this article, I want to show you how best to pick an actively managed fund. So here were the fund options in my wife’s plan just to give you a flavor for what I was dealing with. As you can see, the expense ratios are definitely above average, and the options are not great. However, for this discussion, we’ll focus on just two funds in the large cap blend category: Transamerica Partners Stock Index fund (DSKIX) and MFS Massachusetts Investors Trust (MIRTX).  I am basically trying to decide if I should put some of my portfolio in MIRTX which is actively managed fund or stick to DSKIX an SP500 index fund, which is probably the most expensive index fund on the planet with an ER of 0.65%.

With some research I also find that Transamerica Partners does not track the index (tracking error) very well compared to WCI’s typical recommendation of Vanguard. For example, in 2014, DSKIX had a return of 12.93% compared to the SP500’s return of 13.69%. This is a difference of 0.78% which represents 0.13% difference compared to its ER of 0.65%. If we look at Vanguard 500, the return during 2014 was 13.64% which is 0.05% lower than the index, which exactly equals its expense ratio of 0.05%. Not all index funds are created equally.

So is MFS Massachusetts Investors Trust a better fund holding? We’ll look at this active fund in multiple categories to assess it. This information can be gleaned from Morningstar.com, the fund prospectus, and the fund’s Statement of Additional Information (SAI).


a. Capital invested. How much capital do the fund managers have invested? Do they eat their own cooking or do they take all the fees they earn and plow them into other investments?  A successful fund manager should be rich because their fund has done well over many years. They should be rich enough to have over $1 million invested in any fund they manage. From the SAI, we see the two managers are T. Kevin Beatty and Ted Maloney. T. Kevin Beatty has over $1 million invested and Ted Maloney has $100,000 to $500,000 invested. Ted Maloney started as a manager in 2012 so we’ll give him more time to get his numbers up. This is a PASS.

b. Manager Compensation Structure. How are the portfolio managers compensated? Compensation should be tied to performance over long periods of time. Active management cannot be successful over the short term because there is too much competition in the short term, and the efficient markets hypothesis is most accurate over the long term. Per the SAI, MFS has structured the majority of their compensation to be performance based with primary weight given to the previous 3 years of outperformance relative to the SP500 index. So not only are these managers eating their own cooking, but their pay gets cut by more than half when they don’t outperform the index over the prior 3 year period. I’d like to see previous 5 years of performance weighted the highest, but 3 years is pretty good so this is a PASS.

c. Manager turnover. ­ How long have the managers been in place? Does the fund shop retain good people? Generally you want to see at least one of the fund managers has at least 5 years experience at the fund, preferably 10 years. In this case Beatty has been around since 2004, and Maloney since 2012. This is a PASS.

d. Investor focus. Does the parent introduce funds to catch the latest investment fad? Right before the internet bubble, several fund companies were introducing Internet tech funds focused exclusively on internet stocks. This garnered large amounts of assets under management for the fund shops involved, but shortly thereafter these funds all tanked and investors took heavy losses. MFS is more than 90 years old and largely has avoided trendy offerings. This is a PASS.

Low costs

As WCI will tell you, low fees are the most significant indicator for future performance, and it makes sense because the higher the fees, the higher the hurdle for the fund managers to overcome to outperform the index. But the ER itself is not the only indicator of expenses. We’ll consider it first though.

a. Expense ratio. ­ At 0.97%, this certainly isnt the cheapest large cap blend fund one could find, but it isn’t the most expensive either. It does beat the category average of 1.08%. But it has a 12b-­1 fee of 0.50% which represents a “distribution fee”. I won’t delve into what that is, but one should always look at the share class being offered. In the case of MIRTX there are a total of 12 different share classes, 3 for 529 accounts, 4 for general distribution, and 5 for retirement accounts with ERs ranging from 0.38% to 1.52% and variable 12b-1 fees. Why the variance? It depends on how it is being sold, and how much money is being contributed by a particular client. To get the lowest expense ratio, it would have to be a 401k of a very large company with significant assets. In the case of my wife’s plan which is offered by a small business, they don't have the negotiating power or the scale to get the lowest cost. This represents a NEUTRAL.

b. Turnover and hidden costs of trading.­ What about costs that are not included in the ER? Every time a fund makes a trade in its portfolio, the trading costs are borne by the fund but not reported in the expense ratio. Therefore a high turnover strategy with frequent trading is more expensive to operate than a low turnover strategy. Low turnover also indicates longer holding periods and is typically indicative of classic value investing. Over shorter time periods the efficient markets hypothesis does not work as well so the mispricing of securities in the short term gives active management the opportunity to be successful over longer time periods when mispricing generally corrects itself. The turnover can be found on the Morningstar “Portfolio” then “Holdings” tab, and it stands at 18%. Anything lower than 20% is good. This is a PASS.

c. Tax cost ratio. Taxes are not an issue in 401ks but in taxable accounts they can make a high-performing actively managed fund into a loser. The tax cost ratio indicates how much of the performance is taken out as taxes each year and can be found on the tax tab at Morningstar. Over 5 and 10 year periods the the tax cost ratio has been between 0.7 and 0.77% which is pretty good. In comparison, DSKIX has had a ratio between 0.5 and 0.56%. This is a PASS.

Investment process

a. Low portfolio turnover. ­ Not only does it reduce costs, but it generally improves long-term returns as discussed above.

b. Value investing philosophy. ­ A value investment process is the only way to have a chance at beating the market over long periods of time. Value investing primarily means buying good companies at a discount to fair value, usually because their sector is out of favor right now (think Exxon Mobil) or because the company has had temporary setbacks in their own business that have upset investors but do not affect the long term appeal of the underlying business (think Johnson and Johnson with their consumer product factory problems a few years ago; or some might say Volkswagon right now with the current emissions scandal). The prospectus and annual report can give you info about the managers’ style or the analyst report at Morningstar can give you this info. With research, I find that MIRTX follows a value investing process that it has followed since 1924. This is a PASS.

c. Team approach or solo manager. ­ There are generally 3 approaches to management of a fund.

i. Single­ manager approach. In this setup, one person takes primary responsibility for making the fund's investment decisions. The manager doesn't do all the research, trading, and decision making without help from others, though. The single manager is sole decision maker, not the sole idea generator.

ii. Management team. This approach was first popularized by families such as American Century and Dodge & Cox. Here, two or more people work together to choose stocks. The level of one team member's involvement or responsibilities can be tough to gauge, though. Sometimes there's a lead manager who is the final arbiter, while other times it is more of a democracy.

iii. Multiple­ manager system. The fund's assets are divided among a number of managers who work independently of each other. American Funds is the biggest fund family using this approach. Vanguard uses this approach for its actively managed funds. In general, a team based approach or multiple manager system is favorable because if the manager departs, you are left with other managers with experience at the helm. With two managers at MIRTX, this is a PASS though I would prefer a 3 person team or multiple manager approach.

d. Sector Avoidance. Do they avoid certain sectors? Stocks fall into one of three “super” sectors­-cyclical, sensitive, and defensive­, which are subdivided into sectors, bringing the total number of sectors to 11. The cyclical supersector includes the basic materials, consumer cyclical, financial services, and real estate sectors. In the sensitive supersector, there are the communication services, energy, industrials, and technology sectors. And finally, in the defensive supersector, there are the consumer defensive, health­care, and utilities sectors. You need to know how heavily a fund invests in a given sector so that you are aware of how vulnerable it is to a downturn in that part of the market or how much sector risk it's taking on. Some funds will entirely avoid the cyclical supersector and stick only to the defensive supersector. You would expect a fund like this to be of lower volatility, to provide ballast during a stock market downturn but to lag during a bull market. Other funds are leveraged and weighted more heavily toward cyclical stocks. You would expect a fund like this to perform the opposite way, outperforming during a bull market but taking painful losses during a bear. Since emotional responses to investing are much more pronounced on the downside than on the upside, I prefer more defensive funds. With MIRTX, there is no large deviation from any particular sector. So I will not expect any tremendous deviation from the index. This is a PASS.

e. Closet Index Fund? Are they really an index fund? WCI would tell you to find an active fund that is really an index fund, but I disagree. If I am paying for active management, they need to be different from the index fund. I am not going to pay extra for closet indexing. Active share is a metric that can be used to determine this. Active share tells you how similar to the index the fund is. Active share is not reported by funds or by Morningstar, and I was unable to find the statistic for MIRTX. A few articles in the financial press over the past several years have reported this measure on multiple large funds. It is something to look out for. Since I can't find the info for MIRTX, this is a NEUTRAL.

f. Asset Allocation and Concentration. Look at the portfolio ­ do they own small or mid caps or international? are they concentrated or broadly diversified? Some funds will gain outperformance by weighting more heavily to small cap stocks, but since we know from the Fama French model that small cap stocks outperform over long periods, this is “cheating” and not really active management. Click on the portfolio tab at morningstar.com. we can see 90% is in US stock, 9% is in non US stock, and cash is at 1%. You can also see the sector weightings of the fund vs the SP500. I can see that there is not too much deviation for this fund from the index with all sectors getting some representation in the index. This is a PASS.

Investor Returns ​­

Investor returns track how well the average investor performs in the fund compared to what the fund reports as it returns. [It's a dollar-weighted versus time-weighted return comparison-ed.] It generally indicates how well investors have been able to stick to the process and stick with the fund even during periods of underperformance. Generally funds with a big mismatch between investor returns and total returns tend to be more active, more concentrated, more volatile so that when there is grand outperformance the fund garners most of its assets and when there is severe underperformance, the same investors bail from the fund. MIRTX over 3 and 5 years has investor returns roughly matching total returns. This is a PASS. [This measure has issues as a measurement of investor behavior in that the dollar-weighted return will lag the time-weighted return in a bull market and vice versa.-ed]


How long has the fund been around? In all studies of active management, it is often cited that the average active fund underperforms the average index fund, but the statistics would even be worse if active funds that close or die off were included. The best way to avoid an active fund that might fail is to pick only funds that have been around for a long time. Namely funds that have existed for at least 10 years. Also don't pick a fund that is too small that it could easily fold if it doesn't attract enough assets. MIRTX happens to be the oldest mutual fund in existence, and it has $7 billion under management so this fund isn't going anywhere. This is a PASS.


a. Don't Buy 5 Star Funds. Jason Zweig said, “From financial history and from my own experience, I long ago concluded that regression to the mean is the most powerful law in financial physics: Periods of above-average performance are inevitably followed by below-average returns, and bad times inevitably set the stage for surprisingly good performance.” Don't buy a 5 star fund. ­ The most common mistake that mutual fund investors make is to buy only funds that are rated 5 stars by Morningstar.

This is what I did with my first 401k. I thought, “I’ll only pick the most successful managers.” A few years later during the financial crisis, I found out this is the wrong strategy. Not only had my outperforming funds dropped significantly due to the bear market, they were also now rated 1 and 2 stars, in other words underperforming relative to other funds in their categories. It is normal for active funds to outperform on some occasions and to underperform on other occasions. This behavior is called mean reversion. Investors try to offer all sorts of explanations as to why a fund is doing poorly currently or doing great later, but the simple explanation is mean reversion.

Mean reversion is simply the fact that investments can trade far above or far below their long­term average returns for periods of time, but in the end they eventually tend to move back towards their average. Outperformance is followed by underperformance and vice versa. Because of mean reversion, you should never buy a fund that is rated 5 stars. The best strategy is to buy only funds that are 3 stars or 4 stars that meet all of the other criteria. For an explanation of the star rating system, see this document. Right now MIRTX is rated 4 stars. Over the past 3 and 5 years, it has been 3 stars. This is a PASS.

b. Only Long-Term Performance Matters. Always look at performance over long periods of time. Active management cannot be successful over the short term because there is too much competition in the short term, and the efficient markets hypothesis is most accurate over the “long” term. So when you are looking at return statistics, ignore the 1 week, 1 month, 3 month, 6 month, and 1 year returns. In fact, even the 3 and 5 year returns are not the most reliable. The reason for this is that returns must be considered in the context of a full market cycle.

Many value investing funds and even Berkshire Hathaway have lagged broad market indices over the past 3 and 5 years. The main reason for this is because the past 5 years no longer include a bear market, and value investing funds and Berkshire Hathaway carry a lot of cash on their balance sheets that tends to only be deployed when stocks become much cheaper as in a bear market. So a fund that has outperformed over the past 5 years might be leveraged, might hold cyclical stocks with leveraged balance sheets. When a bear market inevitably comes, this outperformer will turn into an underperformer. Long term returns over a full market cycle matter the most. 10 year performance on MIRTX has been above average and risk has been below average. This is a PASS.

c. Use the correct benchmark. ­ In the case of MIRTX, the benchmark is the S&P 500. It has matched the SP500 over the past 10 years, and slightly underperformed over the past 3 and 5 years. Because DSKIX’s ER is so high, MIRTX has done even better relative to DSKIX. This is a PASS. However, some funds that are in the large cap category might hold many small cap and mid cap stocks, and so a blended index might be a more appropriate benchmark. An international fund might have a large stake in emerging markets so a blended index of international and emerging markets might make the most sense. If an international fund hedges their currency exposure, they should not be compared against funds that do not or an index that does not. Never compare an international fund to the S&P 500.

d. Fund Closing Policy. Do they close the fund if they cant find enough opportunities? Fund closure to new investment is important. If a fund is doing well and a lot of new money comes in, there is a good chance that the manager will have a hard time deploying the new money into worthy investments without diluting the returns of existing shareholders. To combat this phenomenon, the manager will close the fund to new investments. Closing the fund is the responsible thing to do even though it will limit the fees that the manager can take in. Some fund shops show good stewardship and close funds when they become too large. However, buying a fund right before it closes can be a bad thing because that can mean buying it while the fund is popular, and because of mean reversion it may underperform after closure. So it’s important to asses the fund size and look into whether the fund shop closes their funds that are doing well. In the case of MIRTX, the total assets of $7 billion are certainly manageable for a large cap fund. If this were a small cap fund, this would raise a red flag because it is difficult to be nimble with such large assets. Doing a google search on MFS, I find an article that shows that MFS has closed its funds in the past so we can expect it to do the same with MIRTX if there is a need. This is a PASS.

This concludes my review of how to pick an active fund. There are many other things one can consider including alpha, Sharpe ratio; however, I feel the most important are listed above. As you can see, MIRTX passed on almost every metric so we decided to invest a portion of assets in this fund. Because of my agnosticism regarding passive and active strategies as mentioned above, we still did put some into the DSKIX fund, even though I expect MIRTX to do better than it over long periods of time. I ran through this same exercise on each of the funds in my wife’s plan to come up with a usable set of funds for complete asset allocation.

[Editor's Note: This piece was lengthy, but I felt worthy of running here. However, I've timed its publication to run the same week as my recent post about dealing with a bad 401(k). As you might expect, I'm going to make a few comments, some of which I already made in the other post. First, it is a rare situation where someone is stuck in a terrible 401(k) for a long period of time. Does it happen? Sure. On a recent shift, I spent a few minutes going over the 401(k)s for two of the largest hospital systems in the country with my nurses. Both of them had at least two index funds with an expense ratio of 0.25% or less. 

Second, as he pointed out, all index funds are not created equal. There are basically three things to look at with an index fund- what index, how well is it tracked, and at what cost. The main reason index funds work isn't the efficient market hypothesis, but the cost matters hypothesis. So, as you might expect, an index fund with an ER of 1.5% a year isn't going to look very good when compared against many actively managed funds. Even a low cost index fund might only beat 55% or so of the actively managed funds in its category in any given year. But over the decades, that number creeps up to 80% or 90%, and identifying the other 10% a priori is extremely difficult. But if you saddle the index fund with a 1.5% ER (or even a 0.5-1% ER) the chances of it outperforming may be much lower.

Third, the author of this piece eliminates the best way to deal with a crappy 401(k) out of hand just to avoid a very small amount of hassle. The best way is to look at your entire portfolio as one big portfolio. Then you build around the least bad fund or funds in the 401(k). Almost every 401(k) has a reasonably priced S&P 500 Index Fund these days. Probably a decent bond fund too. So use those, and round out your asset allocation using your Roth IRAs, taxable account, and other accounts.

Fourth, there are basically two schools of thought if you are forced to use actively managed mutual funds. The first is to choose a closet index fund. Most of Vanguard's actively managed funds are closet index funds. They keep expenses really low and are broadly diversified. Well, guess what? If you own 500 stocks in any given asset class, you're going to get performance that is pretty darn close to the index performance. The second school of thought is that if you're going to actively manage, then actively manage. Concentrate your best investing ideas as much as the 401(k) legal structure allows you to do so. Your 21st best idea isn't nearly as good as your 3rd or 4th best idea, so concentrate, concentrate, concentrate. This is your best chance to really whallop an index fund, although it comes at the risk of dramatically underperforming an index fund. 

But if I were in the situation of the author's wife, I'd simply pick a closet index fund or two out of the 401(k) and build around it using my 401(k), Roth IRAs, and taxable accounts.  If you graph MIRTX against the Vanguard 500 Index Fund, the performance looks pretty similar. If that's the best there is, take that and build around it. As you can see, due to its higher expenses, MIRTX beat DSKIX over the last ten years. But a similar Vanguard index fund beat both of them. On the day I made this comparison (12/28/15), the 10 year annualized returns for each of these funds were:

  • VFIAX (Vanguard 500 index fund): 7.28%
  • MIRTX (Actively managed fund): 7.21%
  • DSKIX (High expense ratio 500 index fund): 6.64%

What's the moral of the story? Cost matters. The higher the expense ratio, the lower the chance an index fund is going to outperform its actively managed peers. If your only options are a high expense ratio index fund or an actively managed fund, you might as well look at the actively managed one since that index fund has lost its primary advantage over the active fund. But if you've got a good index fund option, there is little sense in running manager risk.]

What do you think? Do you buy actively managed mutual funds? Why or why not? Are they concentrated funds or “closet indexers?” Are you stuck in a 401(k) with all or mostly actively managed funds? How have you dealt with that? What data points do you use to make decisions about funds?  Any factors not listed here that you considered? Comment below!