Summary: There are still some mutual funds that outperform, and you can grow wealthier by using them instead of index funds.

You have heard here in the past, and from most of my counterparts, that index funds and ETFs are the way to go, and to do otherwise is a fool's errand. Index funds have lower costs, and will beat the majority of mutual funds over time.

There are myriad reasons why most mutual funds underperform. The fact is, mutual fund companies are primarily asset gatherers. They do not benefit from outperformance, unless it gains them assets. They only get revenues from assets under management, not their performance. Investors being the herding animals that they are, if a fund outperforms most years and then has a bad year, money will pour out of the fund like a leaky bucket. The CEO, being a good businessman (or woman), will recognize that the most profitable way is to try and immunize the fund from underperformance. The solution is to make sure that your fund keeps up with your competitors. For example, if the rival funds are piling into energy stocks, you had better have the same exposure, or risk being left out. In the end, funds mimic each other so that they don't risk losing clients.

Also, financial advisors are more concerned with keeping their clients in the correct Morningstar style box for diversification than in creating the highest possible terminal wealth. That is why the best managers that go anywhere for returns are penalized by Advisor Joe, CFP who is only concerned with whether a fund can be labelled large value or large growth. Advisor Joe would much rather put you in a bloated, underperforming fund with a static mandate than an outperformer that disregards style boxes.

How can you profit by this? Look for these characteristics:

• DO NOT USE massive, bloated funds. If a manager outperforms frequently, and their fund increases in size from a few hundred million to 10+ billion dollars, the fund is much less likely to outperform (i.e. Fidelity Contrafund). The smaller the fund, the better.
• Look for funds that are not "closet indexers." If it performs like the benchmark index every year, disregard.
• Find funds with a history of outperformance. The best managers, regardless of style, outperform over longer timeframes.
• Select managers that are not concerned with fitting a particular style box and invest based on a theme, such as future inflation.

Do you want an example? Hussman Strategic Growth picks quality stocks that the manager (Hussman) believes will outperform. Then he hedges the portfolio (incrementally removing the stock market risk) based on his views of how cheap or expensive the stock market is at the moment. If stocks are cheap (based on historical average valuation) and the market has positive momentum, there will be little or no hedges on the portfolio. If stocks are expensive and the recent market action is poor, the portfolio will be fully hedged. Another example is CGM Focus by Ken Heebner (underperformed in this bear market, but overall a good fund) that doesn't correlate highly to the stock market. Just remember, if you want a solid portfolio without much effort, just use indexes and forget about it. But if are willing to put forth the effort, there are opportunities in mutual funds.