NEW YORK ( Thestreet) -- When Internet stocks crashed in 2000, many actively managed mutual funds went off the rails. Technology-heavy portfolios suffered big losses, lagging the S&P 500 by wide margins.
To avoid trailing so badly again, some managers stopped overweighting particular stocks or industries. Instead, funds began keeping their industry weightings close to the figures of the benchmarks. If the S&P 500 had 17% of its assets in technology, then the managers would hold a similar weighting. The aim was to keep returns roughly in line with the index -- and avoid antagonizing shareholders.
To appreciate how cautious funds have become, consider a measure known as R-Squared that ranks funds on a scale of 0 to 100. Index funds that move in lockstep with the benchmark have an R-Squared of 100. With many managers playing it safe, the average large blend fund has an R-Squared of 96, according to Morningstar. Funds that score higher than the average could be closet indexers -- which charge high fees for active management but deliver index-like returns.
To beat the benchmark, look for managers that differentiate themselves. Among the most distinctive choices are focused funds that typically hold less than 40 stocks. Focused portfolio managers place sizable bets on a few names, hoping to score big gains.Top-performing focused funds include Virtus Small-Cap Core (PKSAX) and Invesco Endeavor (ATDAX). Both funds topped their benchmarks by wide margins and recorded R-Squareds of less than 90. While many focused funds can be volatile, Virtus is particularly notable because it has held risk in check. In the turmoil of 2008, Virtus topped its average peer by 7 percentage points. During the past 5 years, the fund returned 12.1% annually, outdoing peers by almost 2 percentage points. The portfolio managers aim to limit risk by sticking with the highest quality companies. Holdings must have strong balance sheets and secure market niches. "We want to find companies where there is little risk that profits will be disappointing," says Portfolio Manager Jon Christensen. Such rock-solid companies rarely sell at big discounts. But Christensen seeks to avoid overpaying by waiting until some temporary problem depresses the shares a bit. Once he buys, the manager holds on for years. His aim is to ride along as companies deliver consistent earnings and increase market share. Virtus only turns over 15% of its portfolio annually, compared to a figure of 87% for the average peer.