A recent article from Investment News discusses a simple approach to choosing actively-managed mutual funds: Focus on those funds that simultaneously have low expense ratios and managers who “eat their own cooking.” The article states

“The real eye-opener, however, is when you look at funds with both low expense ratios and managers who invest at least $500,000 in their own funds.

That leaves only 55 funds, most of which have household names like American Funds, Fidelity, T. Rowe Price, and Vanguard. But more than half of this group, 55%, has beaten the S&P 500 over the five years ending March 26.

If you stretch the time horizon to 10 years, the group does even better. Nearly seven out of 10 of these funds beat the S&P 500 over that time period.”

So, assuming that in the next 10 years the odds of picking a market-beating fund hold at approx. 70%, what percentage of assets should an investor devote to such funds? The answer can be derived from the Kelly criterion:

f = 2p – 1

where f = fraction of assets to invest with managers screened in the above manner, and p = probability of selecting an index-winning manager. The formula is intuitive: Suppose p = 50%, which means an investor has an even chance of selecting or not selecting the index-beating managers. Then f = 0%, i.e. the investor should not bet at all. On the other hand, if p = 100%, then the investor is assured to pick index-winning managers, so he/she should invest f = 100% with them.

With p = 70%, f = 40%, with the assumption that the investor periodically reassesses the situation and reallocates his/her investments (i.e. it is like a series of bets on active managers). This implies, though, that the rest, or 60%, of the investable assets should go into passive index instruments. However, if the timeframe is five years and p = 55%, then the bet on active management should only be 10%.

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