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Last year, for the first time in 15 years, Bill Miller’s Legg Mason Value Trust failed to outperform its benchmark, the S&P 500 index, in a calendar year. If history is any guide, now is the perfect time to add more money to Miller’s fund.

Research shows that most equity mutual funds do not outperform the market, and in fact, the average equity mutual fund will slightly underperform the market over long periods because of fees and expenses. Worse yet, numerous studies have shown that most investors do worse than the funds they invest in because they tend to put money in after a fund has had a big run-up.

By chasing past performance, few mutual fund investors beat the market over the long term. Those who do share three traits: first, they only put money with managers whose strategy they agree with; second, they care more about the manager of the fund than the company offering the fund and third, they add to their investment when a good manager hits a slump.

The significance of trait number three is vastly underestimated by most people. The big problem with many actively managed funds may be the behaviour of the fund’s investors rather than the fund itself (although I am no apologist for most mutual funds, many of which are useless investment vehicles in the age of exchange traded funds and index funds). In any event, if you force yourself to follow a contrarian strategy rather than chasing performance, you have a fairly simple way to beat the market by investing in actively managed equity mutual funds.

The first step is to find a few good managers. There are maybe 30 great mutual fund managers (including Miller) and about 200 good ones. Most of the others are “benchmark huggers” and trend-followers more concerned with gathering assets than generating market-beating performance. So out of the thousands of equity mutual funds offered to investors, there are perhaps 230 funds you can use to employ this strategy.

Step two is to divide a portion of your portfolio among a few of these above-average managers. Keep the rest of your equity allocation in index funds for the time being.

Step three is to carefully follow each manager’s quarterly returns. If a particular manager equals or outperforms his benchmark in a given quarter, do nothing, just maintain your investment with him. But if a manager underperforms his benchmark, increase your bet by moving index fund money into the actively managed fund. The worse a manager underperforms, the more you should increase your bet with him or her and the more you should decrease your bet on the index fund. Do this repeatedly over a number of years. Each time the manager has an average or great quarter, do nothing, just sit tight.

Over time, this is an effective way to do better than the overall market (assuming you have not picked a manager who chronically underperforms). In fact, this strategy works even if the manager does not beat the market over the long term because you are dollar-cost averaging and buying more when the fund is poised to rebound and less when the fund is about to underperform the index. Inevitably, there will be good quarters and bad quarters. Take advantage of this, rejoice when a good manager has a bad quarter or year. This is something to be excited about unless you are not able to put any more money with the manager.

As an example, we can look at some data on Legg Mason’s Miller. Using Morningstar.com, I downloaded Miller’s returns in each of the past 32 quarters (1999-2006). Interestingly, Miller has underperformed the index in 15 of the past 32 quarters, almost half the time, in spite of beating the index in seven out of eight of these calendar years.

There have been several rolling 12-month periods when Miller has fallen behind the market, but only one calendar year in the past 16 in which he has underperformed. Over the long term, his fund has beaten the market by a wide margin.

Miller’s compound annual return from 1999-2006 was 5.6 per cent compared with 3.1 per cent for the S&P 500. So in this case, simply buying and holding the fund would have worked well. But by putting more money into Legg Mason Value Trust whenever Miller had a bad quarter, and doing nothing when he had a good quarter, you would have done even better than Miller did. How much better? It depends on how much money you add when the fund is down, and I do not have a magic formula to tell you that. It depends on your liquidity situation and tolerance for volatility.

Unfortunately, most investors do the opposite of what I am proposing, investing more after a manager has a good quarter or year and doing nothing (or pulling money out) after a bad quarter or a bad year.

By following a contrarian strategy instead of chasing performance, you stand a good chance of doing better in actively managed mutual funds than you could by investing in index funds.

Mark Sellers is the former chief equities strategist at Morningstar who manages a hedge fund, Sellers Capital, based in Chicago. msellers@sellerscapital.com

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