How To Select A Top-Flight Manager

• Paul Katzeff
• On 5:49 pm EDT, Tuesday September 8, 2009

Live managers are taking it to the robots this year. Actively managed U.S. diversified stock funds are outperforming passive index funds for periods ranging from year-to-date to 10 years.

Actively run U.S. diversified stock funds were up 20.06% on average this year vs. 14.77% for S&P 500 index funds and 16.67% for all index funds through Aug. 31, according to Lipper.

Over the past 12 months, it's -18.46% for active funds vs. -19.65% for passive funds. And active funds are ahead of index funds -5.28% vs. -6.22% over three years.

Active managers rarely look so good on average. Passively managed funds usually outperform. Proponents of index funds assert that's because they're basically an average of their universe minus excess expenses and trading fees.

So should you avoid actively managed funds? No. Just the average ones.

The better question is, what's the best way to seek outperformance?

First, do not settle just for looking up funds that are leading the year-to-date parade. That will show you funds whose strategy is geared to the here and now, but not necessarily to the long haul.

For instance? There's $1.8 billion Legg Mason Opportunity (NASDAQ:LMOPX - News). It is a well-known fund. Its lead manager is high-profile Bill Miller.

Its eye-popping 65.12% gain this year, going into Tuesday, puts it eighth-best among U.S. diversified stock funds, and nearly 51 percentage points in front of the S&P 500.

But over the past one, three and five years it is trailing the bogey. And it has not been around long enough for a 10-year record.

Also, many year-to-date leaders leverage their bets -- often short positions -- by borrowing. In a down market, that can produce gains. But in the longer run it multiplies risk.

You avoid most, if not all, of those problems by screening for funds that outperform over a much longer period. Look at a list of top performers over the past 10 years.

Bye-Bye, Borrowing

Gone from the list are funds that leverage returns by borrowing cash.

In their place are a slew of sector funds. You might use certain ones to bet on specific macro trends. They can supplement your core portfolio.

But for your core buy-and-hold strategy, you'll likely stick with diversified stock funds.

So refresh your search, limiting it to diversified stock funds.

The list is still heavy with familiar funds. Among the top 20: $3.6 billion CGM Focus (NASDAQ:CGMFX - News), $80.3 million Bridgeway Ultra-Small Company (NASDAQ:BRUSX - News) and $402.8 million Turner Emerging Growth (NASDAQ:TMCGX - News). Asset sizes are as of July 31.

Also on the list: $1.5 billion RS Partners (NASDAQ:RSPFX - News), $2.1 billion Buffalo Small Cap (NASDAQ:BUFSX - News), $997.3 million FBR Focus (NASDAQ:FBRVX - News) and $1.3 billion American Century Small Cap Value (NASDAQ:ASVIX - News).

Average annual returns for the top 35 funds range from 10.10% to 18.54%, as of Aug. 31. As a group, their average annual return was 11.41% vs. 2.18% for U.S. diversified stock funds overall and 1.62% for all index funds.

The price of this outperformance is short-term volatility.

CGM Focus, for instance, was down 0.41% this year vs. gains of 21.06% for U.S. diversified stock funds and 14.77% for S&P 500 funds.

But the fund outperforms over periods of three years and longer.

The top 35 outperform despite an average expense ratio of 1.23% vs. 0.71% for all index funds.

This list of 10-year top performers includes CGM's Ken Heebner, Bridgeway's John Montgomery and Turner's Frank Sustersic. It also has Buffalo's Kent Gasaway, Robert Male and Grant Sarris. Royce's Charles Royce and Whitney George are among the top 20. So is Fidelity's Joel Tillinghast.

The all-star roster shows that many of these funds are run by managers who have repeated past success.

Manager tenure for the top 35 funds averages 8.36 years vs. 5.07 years for all U.S. diversified stock funds, according to Morningstar.

Buzz up!