Although not always winners year-over-year, low-cost index and exchange-traded funds that simply mimic the markets have been gaining ground on actively managed funds.

Over the past 10 years, 55% of large growth funds in the U.S. have failed to beat the Russell 1000 growth index and 69% of large value funds haven’t kept up with the Russell 1000 value index, according to Chicago-based Morningstar Inc.

Among mid-cap funds, the track record is similar, with the poorest performance coming from mid-cap value funds, in which 77% of funds failed to keep up with the Russell mid-cap value index.

Keen efficient marketers insist the odds of beating the market over time are no better than winning big in the lottery. But this does not mean active managers can’t get it right at least some of the time. Although few, if any, managers can top the market year in and year out, a great many of them can outperform it during certain parts of the economic cycle, maintain Doron Avramov and Russ Wermers, both finance professors at the University of Maryland.

A manager who performs well in a recession, for instance, or when commodity prices are booming, may well lag the market in periods of high inflation. And style differences play a further role in keeping certain managers on or off the podium each year.

Most managers suffer when their long-term performances are compared with a market average, the professors say, because the good times will largely be offset by poor performance at other times. The key, they maintain, is identifying and anticipating these probable periods of strong performance and capitalizing on them.

To see who might outperform and when, the professors matched fund returns with four popular leading indicators: the 90-day T-bill interest rate, the rate gap difference between T-bills and longer-term treasuries, the spread between junk bond yields and higher-quality issues, and the stock market’s dividend yield.

Hypothetical portfolio

To develop a system, the professors built a hypothetical no-load portfolio that invested monthly in those particular funds that had enjoyed the best historical performance when these four economic variables were similar to that particular month’s readings. They then retro-tested this portfolio, going back to 1980.

The professors found slightly more than 30% of managers in the study showed significant market-beating ability in certain phases of the market cycle. This was in sharp contrast to the roughly 10% who had been able to beat the market’s overall return throughout all phases.

Over the period under review, the model outperformed the overall market by almost eight percentage points a year, on average. It also bested a benchmark portfolio of funds with a similar risk level and market capitalization, which suggests many managers do display market-beating ability, if only sporadically, say the professors.

A few years ago, Paul Merriman, president of Seattle-based Merriman Capital Management Inc. , initiated an ongoing study intending to develop a system for picking such active funds that don’t require investors to make forecasts or subjective judgments in evaluating and choosing funds.

The result is three portfolios, which Merriman calls “brawn, brains and indexes.” Each contains one fund from each of seven asset classes, which, under the self-imposed rules of this study, can be changed only twice a year.

The Brawn portfolio is based on momentum, representing the way some people invest if they assume that whatever has been doing well recently will continue doing so for at least a while longer.

The Brains portfolio is based on the choices made by fund analysts at Morningstar. That means the fund selection involves some human judgment, although investors who follow this path are not required to make the judgment calls themselves.

The Indexes portfolio is made up of low-cost Vanguard index funds that represent the market in each of the seven asset classes.

Over the past three years, the Brawn and Brains portfolios have been running neck and neck, earning 51.2% and 51.8%, respectively. The Indexes portfolio, on the other hand, has earned slightly less, producing a 47.9% return.

Despite these results, Merriman expects the tide to turn in favour of indexing as the study progresses. Indexing can be beaten, but — if history is any indication — not by much, and not even in turbulent markets, he maintains. IE

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