In active management, you gain more flexibility


Since you could never be sure that a general equity mutual fund would perform as well as an index of stock prices, such as the Standard & Poor's 500, you may have decided to invest at least a portion of your assets in a fund designed to match such an index.

While you knew that such a fund would not outperform the index, you also knew that it should not lag the index by more than a fraction of 1 percent for operating expenses -- in contrast with actively managed funds that may lag stock indexes by a lot more.

Last year, for example, the 9.9 percent total return of the $8.5 billion Vanguard 500 Portfolio, the oldest and largest fund linked to the S&P; 500, beat those of as many as 408 of 1,072 general equity funds tracked by Lipper Analytical Services. The index itself had a return of 10.1 percent, matching its historic long-term average.

Impressive as the Vanguard fund's performance may have been -- according to Lipper, competing S&P; 500-linked funds had returns as low as 9 percent -- it was outperformed by 663, or 62 percent, of the 1,072 funds. As recently as 1989, it had been outperformed by only 21 percent of that year's total of 628 general equity funds.

What happened last year?

Active management paid off for more domestic equity funds than it had in years as portfolio managers seized opportunities to own stocks that became 1993's winners while minimizing their holdings of losers.

They were enjoying the flexibility inherent in actively managed funds but not available to passively managed equity index funds whose portfolios must replicate those of the targeted indexes and remain fully invested in equities regardless of the stock market's behavior.

A study by Paul R. Greenwood, equity research analyst at Frank Russell Co. of Tacoma, Wash., sheds light on how the 1993 performance of U.S. stocks varied among economic sectors and companies of different size and growth or value characteristics.

It does so in the framework of three indexes: the Russell 1000 Growth and Russell 1000 Value, two sub-sectors of the Russell 1000 Index, which consists of the 1,000 largest U.S. corporations, and the Russell 2000, an index of small company stocks.

A portfolio manager who had invested in large company stocks in the same proportions as the Russell 1000 (and whose expenses were low) might have had a 1993 return close to its 10.2 percent -- about the same as the S&P; 500.

If he or she had invested to match the Russell 1000 Growth, Russell 1000 Value, or Russell 2000, the return could have been around 2.9, 18.1, or 18.9 percent, respectively.

But, if able to concentrate in winners and avoid losers, he or she could have achieved much better results.

A manager of a large company growth fund who had avoided health care (-7.4 percent return), consumer discretionary (-0.2), and consumer staples (-4.2) sector stocks -- which together account for 53.4 percent of the weight of the Russell 1000 Growth Index -- might have beaten that benchmark handily. One who had not could have fared worse.

So much for hypothetical scenarios. To understand how stock selection helped actual funds to achieve above-average performance, it's necessary to study the annual reports -- such as those of Baltimore's T. Rowe Price, which advertises that it's the only major mutual fund company able to claim that all of its actively managed U.S. equity funds beat the S&P; 500 in 1993.

Among the 11 Price general equity funds that were in operation all of 1993, total returns ranged from 26.2 percent for Mid-Cap Growth to 13.0 percent for Growth & Income.

They accomplished this:

* By investing in medium-size or small companies, whose stocks, on the average, outperformed those of large companies.

* By investing a portion of fund assets in foreign stocks, which outperformed U.S. stocks last year.

* By picking stocks well.

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