BOSTON (TheStreet) -- In the battle of man versus machine, mutual fund managers must prove their mettle against computer-driven index and exchange traded funds, which have grown in popularity as cheap alternatives.
Assets in ETFs, for example, grew to $1.1 trillion on March 31, more than double the $432 billion at the end of 2006.
Todd Rosenbluth, a Standard & Poor's mutual fund industry analyst, said investors who previously would have put money in large-cap mutual funds are opting for ETFs or S&P 500 index funds. Many continue to use small- and mid-cap stock mutual funds for their hot performance.
And, yet, actively managed funds have outperformed the S&P 500 Index over time, lending credence to the argument that the more nimble of these funds can mitigate downside risk and can take advantage of trends that the follow-the-crowd bet of an index fund can't.
There are 2,504 U.S. stock open-end mutual funds that have a three-year performance record, as of April 28, Morningstar said. Of those, 1,659, or 66%, had a higher return than the S&P 500 Index, though some use other indices as benchmarks.
The fund industry is well aware of investors' drift to passive funds. "Over time, the traditional mutual fund industry is going to have to demonstrate (outperformance) and earn their assets by doing better than ETFs," said Lawrence Rakers, manager of the
Fidelity Dividend Growth Fund
. "And that's what we do every day."
ETFs don't select stocks themselves because they're based on indices, and "they can actually misprice securities" since investor sentiment, rather than fundamentals, can sway an exchange traded fund's value.
Actively managed mutual funds should be the first and, in some cases, only choice for most individual investors' portfolios, said James Lowell, the longtime editor of the independent Fidelity Investor newsletter and chief investment officer of the $2.4 billion Adviser Investments money-management firm.
That's because "it's not that hard to find good managers in the actively managed space who, at very little cost, are riding herd on your investment portfolio day-in and day-out and through the tumultuous times" when many people, left to their own devices, pull their money out, he said.
ETFs and index funds, however, require constant vigilance. "They are no better or worse than mutual funds, or stocks and bonds, but they increasingly require more legwork to keep up with," said Lowell. "And, ultimately, ETFs are designed to meet a benchmark that fund managers spend their whole careers working to outperform."
The eternal issue, though, is how to pick a fund manager who's consistently head-and-shoulders above the crowd.
"This is a question we all struggle with," said Jeff Tjornehoj, head of Lipper's research in the Americas. "What I think it comes down to is that it's really more art than science. Some people seem to have an intuition about the market that their peers do not."
Here are three mutual fund managers who have outperformed their benchmarks and peers over the past three years, along with some of their top picks:
The $10.7 billion
Fidelity Dividend Growth Fund
, managed by Lawrence Rakers since September 2008, has a three-year annualized return of 6% through April 28.
The fund seeks to uncover investment opportunities in either "growth" or "value" companies regardless of size or sector.
Rakers, 47, began his working career "making beer cans" as a metallurgist and engineer for
in the Midwest. He started his investment career many years later by joining an employee-investment club while working for a division of
in Lexington, Mass.
He enjoyed that so much that, after earning an MBA at night school, he applied to Boston-based Fidelity -- several times, in fact, before catching on as a summer intern. "I thought it was great to have someone pay me to do my hobby."
That was 16 years ago. Since then, he has worked his way up through the ranks at Fidelity and now manages a total of almost $14 billion.
He said he considers the resources that Fidelity supplies as "an unfair advantage" to others in the markets, since it includes a team of 120 analysts, researchers, traders and advice from fellow managers.
But don't expect any apologies because managing a 600-plus stock mutual fund is a daunting task.
He said he tracks about 2,300 stocks each day and, on average, has about 40 trades going. The portfolio has an 85% annual turnover rate, meaning the fund almost changes all its holdings once a year.
He said the two principles to his stock selection are the cost of a stock and forecasting a company's future earnings prospects. He said he ranks companies based on those characteristics in a process he calls his "recipe."
The average stock is in the portfolio for a year and a half. When he decides to buy or sell, it's rarely done in one quick transaction. It's usually a gradual build or sell.
As for the outcome, "you take losing money personally," Rakers said, "and I haven't met a single fund manger here at Fidelity who doesn't."
That's obviously not so for index fund and ETFs, he notes, and they can't take advantage of unusual situations.
For example, when the market plunged in March, 2009, Rakers said he saw nothing but opportunity. "Some companies were selling for less than (the cost of) their inventory. I looked at my spread sheet and I saw 80 (stock) tickers that I thought would double. I could just smell free money. So I could make money (in a case like that) when an index fund couldn't."
The fund's top three holdings at the end of February were: iPhone and iPad maker
, bank and mortgage seller
and investment bank
Meggan Walsh has managed the $2.4 billion
Invesco Diversified Dividend Investor Fund
for AIM Advisors since 2003 and has been working in the financial industry since 1987, starting out as an analyst of fixed-income investments.
The large-cap value fund she manages focuses on firms with steady growth potential that are trading at reasonable valuations. Then there is a discounted cash flow analysis that considers a firm's long-term prospects.
Walsh couples that data with a two-year outlook to pinpoint companies with at least 30% upside potential in the near term. Firms that pay solid dividends or have strong share-buyback programs are also favored.
As for the competition with passively managed funds, Walsh said her fund weighs investments over various long-term market cycles rather than for short-term gains, which is in sharp contrast to "the myopic nature of the market we have today (due to) the high-frequency trader and short-term (quantitative) funds."
"It's a luxury" to be able to step back and evaluate the potential of a company over several years and through several market peaks and troughs, she said. "It lets you screen out all the noise."
"Our goal is to provide shareholders with good upside participation with even better downside protection across all (economic) cycles," Walsh said. "We have a full-cycle investment mandate and that's very different from the passive (funds)."
The fund holds 76 stocks and has an annual turnover rate of 13% -- extremely low.
Its top three holdings are consumer paper goods maker
, regional bank
and industrial-pump maker
Todd Ahlsten, manager of the $4 billion
Parnassus Equity Income Fund
since 2001, has steered the fund to a three-year average annual return of 5.8%.
The fund is so-called socially conscious and, as such, it screens out "sin" stocks such as alcohol and tobacco companies, as well as weapons manufacturers and nuclear-power companies.
Compared with passively managed funds, "our clear, defined investment strategy can regularly outperform the benchmark. And we are strong believers that the markets are inefficient and that a defined strategy and in-depth research will outperform over time."
Ahlsten, age 39, said his investment team considers four factors when choosing stocks. First, it must make or sell a product or service that will remain relevant over the long term and hopefully become increasing so, in order to build value.
Then the company should have a wide "moat," a long-term sustainable advantage over competitors. In that case, it can charge higher prices in times of inflation and has downside protection in a recession.
And a quality company management team is an essential part of the screening process. "We want a company that is progressive, has good business ethics and has a good workplace culture."
And, finally, the screening process includes a review of metrics, such as whether a stock is trading at a discount to the company's intrinsic value.
The business model includes evaluating what the stock will trade at in different economic scenarios to develop various price targets. "We look at how much money we can make and how much money we can lose, and we absolutely avoid the loss of capital," he said.
"It's hard to find businesses that meet those criteria, which is why we only own 40 to 45 stocks" at a time in the portfolio, he said.
Current top holdings include: natural gas explorer
, trash hauler
and investment bank
Ahlsten, who joined Parnassus as an analyst in 1995 not long after he got out of college, said he travels as much as 100,000 miles a year visiting companies he may invest in.
"I've been on oil platforms in the Gulf of Mexico, down in coal mines and in oil refineries and visited manufacturing plants" as part of the job, he said.
"We like to look at the assets whenever possible," he said of his nine-man team of analysts and money managers.
The fund's portfolio turnover last year was 54%, but historically it's about 30%, he said. The fund shifts in and out of some the same investments as market conditions change but keeps a long-term time horizon in mind.
For example, he said he's owned
since it went public and at times it's been as high as 5% of the fund's assets or down to 1% or so.
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