An Easier Way to Pick Winning Funds

TheStreet.com

NEW YORK (TheStreet) -- Plenty of investors have become furious at their actively managed mutual funds. During the financial crisis, many star managers sank. Now, frustrated investors have concluded it is too hard to pick the best funds. Shareholders are abandoning active approaches and shifting to index funds.

But if you can't pick winners, maybe you should try some of the specialized fund companies that have long records for selecting successful active managers. These companies hire freelance portfolio managers known as subadvisers. Companies with track records of outdoing the benchmarks include Allianz Global Investors, Aston Funds and Harbor Funds.

The subadvisery approach is different from the traditional system employed by most fund companies, including Fidelity Investments and T. Rowe Price TROW . The traditional companies rely on full-time employees, often hiring young analysts who spend years training to become portfolio managers. In contrast, the subadvisery firms screen through hundreds of independent money managers, seeking to pick the best of breed. Besides handling mutual funds, the freelance management firms also serve a variety of clients, including institutional investors who are known for demanding consistent returns.

Harbor Funds and the other subadvisery fund companies have some key advantages. Instead of hiring rookies, they pick from among management firms with long records of success. Such established portfolio managers would never quit their successful businesses to become employees of another company.

Consider Harbor Bond HABDX , which has outdone 96% of its intermediate-term peers during the past 15 years, according to Morningstar. Harbor succeeded by hiring one of the most successful managers ever, Bill Gross, portfolio manager of Pimco Total Return PTTAX . There is no way that Gross would quit Pimco, the company he founded, but he is more than willing to accept a fee from Harbor for overseeing a bond fund. These days it may seem like a no-brainer to hire Gross. But Harbor was shrewd enough to pick the bond manager more than two decades ago when Gross was not well known.

Should you buy the Pimco flagship or the Harbor version? Most investors should take the subadvised fund because it has an expense ratio of 0.53%, lower than what Pimco charges for its retail mutual funds.

Besides enjoying access to big-name managers, subadvisery fund companies also benefit from the flexibility they have to hire and fire. If a hot freelance manager suddenly turns cold, it is easy to fire him and screen for someone else. In contrast, it may be harder for traditional funds to get rid of long-term employees who are no longer excelling.

Subadvisery firms say that the key to their success is finding money managers that consistently apply distinctive styles. Such managers can repeat their success over long periods. A top subadviser is William Muggia, CEO of Westfield Capital Management, which oversees funds for Touchstone, a subadvised fund family. Westfield manages $15 billion in total assets with two-thirds of the money at institutional accounts and the rest in subadvised mutual funds aimed at retail investors. One of Muggia's best-performing mutual funds is Touchstone Growth Opportunities TGVFX , which has outperformed most large growth funds for the past three, five and 10 years.

Whether he is working for Touchstone or institutions, Muggia follows a distinct growth approach. While many competitors look for consistent growth stocks, Muggia will take either growth or value names that are improving their earnings. "We will take any kind of stock as long we think that the earnings will do much better than Wall Street expects," says Muggia.

Touchstone Growth Opportunities has such traditional growth names as Amazon AMZN and Starbucks SBUX . In addition, the fund has stakes in oil refiners, including Tesoro TSO and Valero VLO . The refiners are normally considered cyclical names that fit in the value box. But lately they have been recording rapidly growing earnings as high international oil prices help to fatten profit margins.

Make no mistake, picking the best subadvisers is not easy, and many companies fail with the strategy. But the best practitioners have demonstrated a deft touch for carefully evaluating managers that can succeed over long periods.

Among the strongest subadvised fund companies is Aston Funds. Of the company's 14 funds with five-year records, 10 have outpaced their category averages. An intriguing choice is Aston/Montag & Caldwell Growth MCGFX ,which has returned 1.7% annually during the past five years, outdoing 75% of large growth peers. The fund buys blue-chips selling at discounts. Holdings include Coca-Cola KO and General Electric GE . The solid stocks have enabled the fund to rank as a low-risk choice that excels in downturns. During the turmoil of 2008, the Aston fund outdid 95% of peers.

Another top performer is Aston/Fairpointe Mid Cap CHTTX , which returned 3.6% annually during the past five years, outdoing 95% of mid blend funds. The fund managers look for industry leaders that are increasing their sales and market shares. Holdings include Southwest Airlines LUV and medical device maker Boston Scientific BSX .

This article was written by an independent contributor, separate from TheStreet's regular news coverage.

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