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Stock pickers make their case, hoping to stem the flow of billions of dollars into index funds

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CHICAGO — Is it worth it to pay a stock picker when index mutual funds are so cheap?

More investors are saying no, and billions of dollars are jumping onto the index-fund bandwagon by the month. Billions are leaving actively managed mutual funds at the same time. It was against that backdrop that several high-profile stock pickers made their case at the Morningstar Investment Conference in Chicago this week. Two of the conference's main discussion panels addressed whether stock picking is dead, as Morningstar released a report showing that the majority of actively managed stock funds fall short of index-fund peers.

"Active management has lost its voice a little bit, and we want people to remember what it's about," said Rob Lovelace, president of Capital Research and Management and a portfolio manager at American Funds, the industry's third-largest fund family. American Funds has been an exception among actively managed funds and has drawn new investment over the last year.

"The debate isn't active versus passive," he said. "Our goals are all the same."

Index funds and actively managed funds can be potential complements, rather than just an either/or proposition, stock pickers say. The benefits of index stock funds are widely appreciated: They charge an average fee of $11 per $10,000, versus $86 for actively managed stock funds, and lower costs mean investors keep more of the returns.

Stock pickers say the difficulty for them is that they typically best demonstrate their worth when the market tumbles -- a rarity since the stock market has roughly tripled since hitting its bottom in early 2009. In a downturn, active managers say they can avoid the worst-performing stocks and help cushion the blow of a bear market.

Of course, actively managed funds didn't do so well in 2008. That's because the financial crisis brought down all sectors of the stock market together, along with economies around the world. That makes it an exception, Lovelace said. In 10 of the last 12 bear markets, he said American Funds did better than index funds. In 2000, for example, American Funds' Growth Fund of America returned 7.5 percent, when the Standard & Poor's 500 index fell 9.1 percent.

The hope is that by blunting the pain of down markets, actively managed funds can help investors resist the temptation to abandon stocks and sell low. That would help them lock in better returns over the long term.

To be sure, most actively managed funds have produced lower returns over the last decade than index funds. That may be because many are built very similarly to index funds, and the only difference between these "closet indexers" and index funds is their higher fees, said Diana Strandberg, director of international equity for Dodge & Cox, which runs actively managed funds

That's why even stock pickers are embracing the focus on low fees that's sweeping the mutual-fund industry. Lovelace suggested investors look not only for funds with low fees and strong track records but also those in which the managers invest their own money in the fund.

Some managers are also looking to sell their services to investors in new, lower-cost ways, such as through exchange-traded funds. ETFs have exploded in popularity, mostly due to demand for those that track indexes.

But more actively managed products may be on the horizon. NextShares, a kind-of ETF hybrid, has signed up roughly a dozen fund managers looking to use the structure, for example. The hope is to launch some by the end of the year, said Jonathan Isaac, managing director of product strategy for Navigate Fund Solutions.

Among other topics discussed at the Morningstar Investment Conference:

— BUBBLE WORRIES

Stocks may not be in a bubble, but they look like they're getting there.

So said Jeremy Grantham, chief investment strategist at GMO. And it's not only U.S. stocks that are expensive. He says valuations are also high enough for many foreign stocks and U.S. bonds that he's forecasting their annual returns will be lower than inflation over the next seven years.

Even so, stocks could still race higher. "We need a trigger to break a bubble," and high valuations alone aren't enough, Grantham said. He said the trigger could come after two hallmarks of past bubbles appear: Individual investors start pouring money into stock mutual funds again, something they've been hesitant to do since the financial crisis, and corporate deal-making gets more frenzied. Mergers and acquisitions have already picked up, with activity at its highest pace since before the Great Recession.

— BOND MANAGERS ARE GETTING MORE CONSERVATIVE

Low yields have made it tough for years to find value, and fund managers say it's getting even more difficult.

Junk bonds offer higher yields than high-quality bonds because of their higher risk, but even their yields are lower than historical averages. Plus, more companies are making moves that reward stock investors but potentially hurt bond investors, such as borrowing money to pay for stock buybacks.

"I think it's OK to dig for some value, but if you dig too deep, you'll find yourself in a hole," said Laird Landmann, portfolio manager at TCW Group.

Managers are also worried about the increased difficulty in finding trading partners, a concept called liquidity. Before the financial crisis, it was easy to sell large blocks of bonds at once. But with new regulations, big Wall Street banks are less willing to be buyers, and bond fund managers say a lack of buyers during the next market tumble could drive down prices even further.

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