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What to do in stumbling market

The Baltimore Sun

Watching the stock market stumble, as it did late last month when the Dow Jones industrial average sank more than 585 points in a week, is unsettling.

In one day that week, the year-to-date return on the Dow went from 10.6 percent to 8.1 percent, casting a pall on even the brightest of summer afternoons.

It's not uncommon to react to these events: Should you pull your money out of the stock market? Should you search for funds with managers who can find stocks moving up instead of down or opt for low-cost index funds that mirror market benchmarks?

The folks at Lipper Inc., a supplier of mutual-fund data, recently took up the last question. They found that actively managed funds - in which a fund manager hand-picks stocks - tend to do well in stable markets (when there are no big swings up or down).

Through the end of June, about three-fourths of diversified U.S. equity funds beat the index, said Andrew Clark, head of research for the Americas at Lipper.

But in periods where the market takes enormous leaps in either direction, so-called passive funds that track an index rule the day.

"When there's a strong move up or down, where almost every stock performs that way, the active manager's skill to pick stocks is swamped," Clark said.

He points to the last quarter of 2005 as an example: For most of the year, actively managed funds excelled. But when the market took off at the end of the year, passive funds outperformed actively managed funds by as much as 3 percentage points, Clark said.

In the current market climate, there may be a case for holding at least a small portion of your investments in actively managed funds and hanging on to your index funds for the long term.

Some things to keep in mind:

Split it.

As a general guideline, Clark suggests investing 50 percent of your portfolio in index funds, such as the Vanguard 500 Index Fund or the iShares MSCI EAFE Index. Over long periods - 10 years or more - studies show that passive funds outperform actively managed stocks.

Why? One word: expenses. Because a manager must research and select stocks individually, actively managed funds tend to charge higher fees than index funds. In fact, the average expense ratio for index funds is 0.73 percent, compared with 1.44 percent for actively managed funds, according to Chicago-based Morningstar Inc., which provides investment information. (The expense ratio is a fund's total expenses expressed as a percentage of the assets in the fund.)

But as Clark noted, actively managed funds will at times outperform. By investing 50 percent or so of your portfolio in these funds, you could boost returns.

Pick funds with care.

How to choose a managed fund is an important consideration. You want value for those higher fees.

Looking at last year's top performers is not the way to go.

Instead, search for funds with good management. You want a fund manager who has been in place for five years or more, Kinnel said. Also, look at the fund's shareholder letter or prospectus. Do it offer thoughtful insights? Do you like the strategy?

And you want a fund with lower expenses than its category peers.

You can search for this information at www.morningstar.com or on the fund company's Web site.

Don't worry if you can't find a managed fund you like right away. "While I think there are many good uses for active management, there are also for index funds," Kinnel said. With index funds, you "don't have to worry about a manager going away or taking on too many assets. If you're a patient investor index funds are a great place to be."


Carolyn Bigda writes for Tribune Media Services.

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