Statistically, the default investments for all of us should be low-cost index funds or ETFs. Research has shown that it is very hard for actively managed funds to consistently beat their respective indexes.  Bill Miller of Legg Mason used to be the poster boy for the rare exception to this rule, but look how his funds (LMVTX and LMOPX) have been doing in recent years.  Now, if you are able to find an actively managed fund with excellent and consistent returns, a consistent investing methodology, stable management, low or relatively low expenses, and relatively low volatility for its category, then this rare fund should be a candidate for inclusion in your diversified portfolio.

Now once you buy this rare actively managed fund, like you said, that is the easy part.  How much patience should you have with this fund going forward ?  How much patience do you have for holding a fund which begins to lag its actively managed fund peers and the respective index funds ? Believe it or not, there are still many folks -- but declining rapidly in number -- who are hanging on to LMVTX and LMOPX because they have "faith" in Bill Miller as advocated by M*.  Well, in my opinion, faith has nothing to do with my investments and has everything to do with my religious beliefs.  In my own portfolio, I have some patience but not the patience of a saint.  If there is an abrupt change in management or if the fund's performance lags over the trailing 2- to 3-year periods, the fund is subject to being replaced by a more stable fund with more consistent performance.  Does this move represent performance chasing or fund upgrading ? I will let you decide. Just be aware that your original fund and the replacement fund are both unlikely to beat their respective indexes over the long haul.  So we are back to using index funds or ETFs for most if not all of your portfolio.

That being said, most of my portfolio is invested in actively managed funds.  Maybe I am fooling myself into believing that my collection of actively managed funds can beat a collection of index funds/ETFs.  Time will tell.

As for my taxable account, I try to hold excellent and tax efficient funds, but I am more than happy to pay more taxes on a killer fund.

Kevin

you are actually an amateur, low-life "Spammer" as 9 out of your past 10 posts have promoted your personal web site.  Please go away and stay away.  You obviously realize that these M* forums are not actively moderated, but I will report you to M* nonetheless. Have a nice day !

Kevin 

I'll be direct and say that you strategy of supplementing your index funds with actively managed funds is flawed. Seriously, if your strategy really worked, then would you be here asking us for advice? I don't care what Charles Schwab has written on the topic. An actively managed fund won't actually boost the return of your index fund. It will outperform it or underperfrom it after expenses, but it will of course have no impact on the index fund, as it has no impact on the underlying index. Now you've asked, "how do you pick your replacement active mutual funds and feel confident that they will be able to beat their asset class index?" My response is simple: if you are confident that an actively managed mutual fund can beat its respective index, why would you bother owning an index fund in the first place?

No, there is no problem managing actively managed funds. If you feel that holding an actively managed funds "isn't easy", then I suggest you stick with index funds, because there really isn't much effort involved in owning mutual funds of any kind.  I can think of a dozen household chores that are a thousand times more difficult than holding a mutual fund.

"If you hold active mutual funds, you need a perpetual strategy to move from active fund to active fund should an active mutual fund manager start to fall behind the index "  No, that's completely wrong and it would merely be a recipe for underperforming the indexes. If you sell an actively managed fund when it begins to fall behind its respective index, then you have locked that underperformance into your returns. What you are talking about is called "chasing returns", which is a strategy that inevitably fails. Sure, there are people on these forums who may claim to do this sucessfully, but I have doubts about their honesty. 

 Sucessful investing in mutual funds requires a long-term commitment, which means you have to be able to stick with a fund through periods of underperforming its peers or its repsective index. I'm not merely parroting some tired old mantra about investing. My personal experience has been that selling a good actively manged fund after a short period of disappointing results has been a mistake followed by an even longer period of regret after these funds vindicated themselves over the long haul. But, it sounds to me like you will probably need to find this out for yourself.      

kevindow:

you are actually an amateur, low-life "Spammer" as 9 out of your past 10 posts have promoted your personal web site.  Please go away and stay away.  You obviously realize that these M* forums are not actively moderated, but I will report you to M* nonetheless. Have a nice day !

I flagged BestReturns' posts as ADVERTISING.   

I struggle with the same issue. My approach is to hold more funds in the same asset class, which is not normal, based on all the recommendations.

I believe there are hot sectors, that drive short term results 1-3 yrs. For instance, the falling dollar made intl better.  brazil, China and russia made BRIC in the past couple yrs.

I moved money from weak performance sectors to higher, yes chasing performance, but not dropping any positions unless the fund performance dropped big time.  So new money and some transfer money was shifted.

I used Fido, and find the portfolio charts very useful.  I look for trends out of sequence with the others.  I don't have any hard an fast rules when to sell,  hence why I'm looking for other opinions.

I've seen many theories, none of which I think will always work.  I try to use the theory and my history of the fund as the test case over the past 1-3 yrs.  If I followed the sell signal,  would that have been a good move?  almost always no.

I will continue to search.  I do reduce my positions once a fund closes, when this happens the fund normally under performs for a while.

First - Tidefan, kevindow, Katmanndu, kerryvan - thank you for your honest feedback on the issues at the crux of active mutual fund investing.  And BestReturns - I take your point about active mutual fund investing requiring strategies which at extremes can look like momentum-chasing or value-chasing plays (but I didn't appreciate some of the advertising comments).

Katmanndu had some great challenges and asked some really good questions but also mis-understood a couple aspects of my original post.  Let me clarify those.

[Katmanndu] An actively managed fund won't actually boost the return of your index fund. It will outperform it or underperfrom it after expenses, but it will of course have no impact on the index fund, as it has no impact on the underlying index...

Let me give an example to clarify what I meant.  Take an asset class.  Let's say foreign large cap blend.  The index is EAFE and for that I hold iShares EAFE (symbol EFA) index fund which I've held since 2002.  But within the same asset class, I also have an active fund Julius Baer International Equity (BJBIX), which I've also held since 2002.  I currently own 73% BJBIX and 27% EFA which has grown out of balance from the 70%/30% point I was at a year ago.  So I will rebalance within the foreign large asset class back to 70% active / 30% index as part of my rebalance.  Every year since I've held both (2002-now), BJBIX has beat the index (EFA) by an average of 4.84%

     http://quicktake.morningstar.com/FundNet/TotalReturns.aspx?Country=USA&Symbol=BJBIX

which minus 1.19% mgmt fees and minus 1.37% (5-yr) tax cost ratio, still leaves me about 2.28% per year (4.84% - 1.19% - 1.37% = 2.28%) ahead of where I'd be if I was holding 100% index (EFA) and 0% active (BJBIX).  So a couple points I want to make with this real-world example.  It is possible to "boost" (i.e. end up with larger actual percentage gain) by holding not just 100% index fund within an asset class but by holding an index fund "anchor" and and active fund "booster" which is comprised solely of holdings within the asset class (else we wouldn't be comparing apples-to-apples nor maintaining balance across asset classes).  And I agree with your comment, Katmanndu, that the fact that I'm holding BJBIX as part of my foreign large cap holdings has zero bearing on the annual performance of the EAFE index itself.  That's not what I was trying to say.  I know they're 99.9999% independent.  However, by holding a blend of both index plus active I was able to "boost" overall return within my foreign large cap asset class holdings which is what I was trying to do.

[Katmanndu] Seriously, if your strategy really worked, then would you be here asking us for advice?  (and)  if you are confident that an actively managed mutual fund can beat its respective index, why would you bother owning an index fund in the first place?

Both are good questions.  I suppose if every active/index asset class pairing I've got played out like BJBIX/EFA holding above, I may not be asking any questions.  :-)  So let me illustrate with a counter-example.  In 2002, I bought 40% domestic small cap index (Russell 2000, symbol IWM) and 60% active mutual fund Bjurmann-Barry Microcap (BMCFX) with which I was trying to "boost" my domestic small cap overall return.  I sold the BMCFX in 2007 and it still sits in cash going into this year's rebalance.  If you look at my overall performance within domestic small cap asset class, at first things look promising.  If you average total returns vs small cap index for years 2002-2007 (+/- Category for years 2002-2007 at http://quicktake.morningstar.com/FundNet/TotalReturns.aspx?Country=USA&Symbol=BMCFX) you get annual total return of BMCFX about 2.02% above the small cap index.  Sounds good.  However, when you consider BMCFX 1.58%/year mgmt expenses and 2.43%/year (5-yr) annual tax cost ratio, then my actual return compared to index is 2.02% - 1.58% - 2.43% = -1.99% per year compared to index.  (Actually I've painted this worse than reality in that even the index fund has a small expense fee and small tax cost ratio, but it illustrates the point.)  So in this asset class category, I'd have been better off (by about 2%/year give or take) just owning the index.  (Note - unfortunately my 401K choices are not great and I couldn't buy either BJBIX or BMCFX in my tax-free acount...if I had been able to, both scenarios would look better for active portion and in BMCFX case I'd actually have been ahead of index in the end.  I've rolled my 401K to IRA which now gives me more chances to improve on tax-costlier active fund holdings in the future and that'd make both scenarios above, even the "bad example" BMCFX, look better.)

Overall, across my entire portfolio, across all asset classes, if you repeat all of the math above, I'm about 0.5% per year ahead where I'd be holding pure indices in each asset class.  I spend about a week solid each year rebalancing and replacing/re-selecting active funds.  So if you look at cost of my time vs return, given portfolio size, for me personally, it's been well worth it.

As far as the question "if I'm confident an active fund can always beat index why not just own 100% active?", the answer is "I'm not".  Everything centers on probabilities.  I'm willing to put a portion of my portfolio at stake based on risk/return that I can beat the index where that portion varies by asset class based on active mutual funds historical abilities to beat the index within a particular asset class.  In the examples above, the ratio is 70/30 active/passive for foreign and 60/40 active/passive for domestic mid-/small-cap but for domestic large cap I use 20/80 active/passive because few active mutual funds consistently beat the S&P 500 (because it's such a small universe to pick from to distinguish, I believe).  So the active/passive ratio is based on a per asset class risk/return point I'm comfortable with.  As a side note, Charles Schwab published suggested active/index mixes based on computed probabilities around year 2000 and I've modified them slightly based on personal observations but would love for someone on the forum to post a pointer to updated active/index ratio holdings per asset class (based on true statistical analysis) if anyone knows of such a thing.  I'm sure the statistical ratios shift over time.

At the end of the day, my mechanisms for reviewing and swapping out under-performing active mutual funds doesn't always work as well as I think it needs to demonstrated by the BMCFX/IWM example above.  So I'm looking to improve how I make the "sell" determination on active mutual funds I'm holding.  If other more experienced active mutual fund investors have good ideas on when to recognize that an active fund isn't performing well compared to its asset class index and exchange it for another active fund WELL BEFORE it becomes an overall loser (including mgmt and tax costs) to holding pure index within same asset class, that's what I'm dying to hear.

[Katmanndu] Sucessful investing in mutual funds requires a long-term commitment, which means you have to be able to stick with a fund through periods of underperforming its peers or its repsective index. I'm not merely parroting some tired old mantra about investing. My personal experience has been that selling a good actively manged fund after a short period of disappointing results has been a mistake followed by an even longer period of regret after these funds vindicated themselves over the long haul. But, it sounds to me like you will probably need to find this out for yourself.

I fully agree with your observations on required discipline and long-term commitment to a plan.  Hopefully, you've gotten a feel that I do have a plan and do everything I can to stick to it.  What's missing in my plan is something you also hint at above.  You say you've made a mistake where you sold a good active fund after short-term disappointing results only to see it recover and go on to vindicate itself in the long-run.  I pointed out the opposite case above where after reading Morningstar analyst opinion and continued 5-star rating, I held BMCFX a year or two too long, I believe.  So you say you have a mechanism which led you to sell an underperforming active fund too early.  My mechanism, which is basically 2-3 years significantly under index, caused me to hold on too long, I believe.  Maybe we combine our approaches to become "just right".  ;-)  But I'm looking for the right hard-and-fast "sell" approach on an underperforming active mutual fund.  I think this is the key to improving my slightly-above-index results to make them more-above-index.

If you're a passive index fund only kind of investor, I suggest you don't weigh in with flame on this thread but let the active investors do their best to call out a real-world mechanism (not gut feel) that enables them to long-term beat indices with active mutual funds.  In my own personal experience, the hard part and the heart of a deterministic mechanism for maximizing asset class returns with active mutual funds portion of holdings is in determining the right "sell" point for active funds.

Sorry for the long note.  Wanted to make things as clear as possible.  Thanks again for all of the thoughtful responses already shared and those to come.

-Andy

As I understand it the returns on all mutual funds is after expenses are paid. So you would not subtract the expense's again when comparing it to a index.

Regards Ron

I don't think your strategy makes a lot of sense.  There's nothing special about the returns produced by an index fund.  Your goal should be to produce satisfactory investment returns over a long time horizon, not to beat index fund by a few basis points per year.  If the S&P 500 is down 50% next year, getting -48% instead isn't particularly helpful.  Cap-weighted indexes have some problems that make them unsuitable investments under some circumstances, particularly when large-cap growth stocks are dramatically overvalued.  The primary advantage of index funds is low cost, which is something you have control over even when investing in active funds. 

If the S&P 500 returns 5% annualized during the next 20 years and you return 7%, you'll have done quite well.  However, you could have underperformed the index 80% of the time and still produced the long-term outperformance you wanted.  It's not necessary to beat the index all of the time.  Strategies that attempt to produce consistent outperformance over a particular benchmark are almost never successful.  In fact, I'm not aware of any strategy that has actually pulled that off. 

To produce long-term outperformance, it's generally necessary to accept tracking error.  That's a fancy way to say your returns may deviate markedly from market/index returns. Sometimes, you'll be down, sometimes you'll be up.  If you want index-like performance because you want to keep up with the Joneses, you will almost certainly do better by just opting for 100% index funds.