The Secret to Picking Actively Managed Mutual Funds

If you are a regular reader of my blog, you know I recommend against buying any actively managed mutual fund. Instead, I advise investing in a globally diversified portfolio of low-management-fee index funds, passively managed funds or exchange-traded funds (ETFs), in an asset allocation suitable for you.

Investors are looking at the data and getting the message. According to Morningstar, passive products captured 41 percent of estimated global net flows in 2012.

But the news is not all good. The same report indicated that 78 percent of worldwide assets under management for mutual funds and ETFs still reside in actively managed funds.

If you are one of those investors, this blog is for you.

You are not concerned with the daunting odds of a portfolio of actively managed funds outperforming its risk-adjusted benchmark. Maybe you believe one or more of the many lies about evidence-based investing, often disseminated by the financial media, brokers and active fund managers.

Whatever the reason, you are convinced you and your broker can "beat the markets" by buying and selling actively managed funds. Since I can't persuade you otherwise, the least I can do is help you maximize the possibility of buying an actively managed fund with a higher expected return.

Here's the secret:

According to a working paper by Diane Del Guercio, Jonathan Reuter and Paula Tkac that was published by the National Bureau of Economic Research, it's prudent to ignore the recommendations of your broker. Instead, you should buy actively managed funds directly from those fund families that sell to investors without any intermediary.

The authors of this study found "robust evidence that funds distributed through the direct channel outperform comparable funds distributed through other channels by one percent per year." It doesn't really matter what the reasons are for this outperformance, but the study provides an explanation. Funds sold by brokers charge higher total fees because of the need to compensate brokers for "servicing investors." The authors surmise the funds recommended by brokers earn lower before-fee returns because they "invest less in portfolio management."

That's their story. You can earn higher returns by avoiding brokers.

Imagine that!

Dan Solin is the director of investor advocacy for the BAM ALLIANCE and a wealth adviser with Buckingham Asset Management. He is a New York Times best-selling author of the Smartest series of books. His next book, The Smartest Sales Book You'll Ever Read, will be published March 3, 2014.

The views of the author are his alone and may not represent the views of his affiliated firms. Any data, information and content on this blog is for information purposes only and should not be construed as an offer of advisory services.