Chapter 29. How to Use Mutual Funds Effectively

There are ways to deal with many of the problems that arise when investing in mutual funds. Much of the solution comes down to investors educating themselves , allowing them to avoid many of the problems and deal more efficiently with those that can't be avoided. This means, of course, that the burden is on investors themselves to spend some time learning about the pros and cons of owning mutual funds. The rewards of doing so, however, can be great.

We now know that the costs of owning funds can vary widely across funds, and that the cost structure often has a big impact on final performance. The obvious conclusion to draw here is that investors should pay close attention to the costs of the funds they own or are considering.

We also know that taxes can make a big difference in the net performance of mutual funds. Traditionally, funds did not worry about the implications of their actions when it came to taxes. As a result of the debacle of 2000, when large capital gains were passed on to shareholders at the same time that mutual fund values were declining sharply, much more attention is being paid to this issue. Investors can find tax-efficient funds, or funds that are being managed with a clear eye on the impact of taxes on shareholders. They can also concentrate on index funds, which are almost always more tax efficient than other funds.

Finally, there is the issue of performance. The popular press touts recent performance, and many investors chase those funds with outstanding recent performance. However, great performance tends not to persist, and many times investors are buying a fund that has performed very well in the past just as it is beginning to do the opposite .

Let's consider some recent evidence on mutual fund performance. Forbes magazine does a fund survey every year and reports rankings and other information for mutual funds. In its early 2002 issue, Forbes reported that only three of the 10 largest fund families beat the S&P 500 Index since 1991. These three families were Fidelity, Vanguard, and American Funds. Whether coincidence or not, they were also the three largest fund families based on assets at the end of 2001. ^[1]

^[1] See "Fund Survey," Forbes , February 4, 2002, p. 96.

How, then, can we best deal with the issues that arise in the course of owning mutual funds? The most effective single way to deal with many of these problems is to own index funds. Recall that index funds attempt to mimic a market index or sector, and are therefore passively managed portfolios. Operating costs are extremely low. One of the two largest mutual funds in the United States is the Vanguard 500 Index Fund, which tracks the S&P 500 Index.

As noted in earlier chapters, John Bogle of Vanguard fame is well known for making the case for owning index funds, and he has written extensively on the subject. He has been a tireless crusader for the average, everyday investor, arguing that such investors can help themselves significantly by not chasing recent performance and by paying close attention to fund costs. His views are must reading for all intelligent investors, and others have also made persuasive cases.

The rationale for index funds comes down to a simple principle: If you can't beat them, join them. Investors in aggregate cannot outperform the market because, in aggregate, they are the market. Therefore, investors, on average, must earn the market average rate of return. For a given period of time, such as one year, some will do better and some will do worse than the average, but longer run almost everyone is destined to perform like the averages.

Or are they? A fly in the ointment is costs. If you earn the market average over time, but give up 1.5 percent of the return in operating expenses, your net performance will be lower than the market average. Recall that the typical equity mutual fund has operating expenses of close to 1.5 percent of assets annually.

Therefore, when we think about it logically, we can see that the majority of investors earn less than the market average over time on a net basis. On a gross basis, investors earn approximately the market average over time. On a net basis they earn less, and the larger the expenses the less the net return.

This is where index funds come in. Because these funds do not engage in trading, research, security analysis, and so forth, their operating expenses are quite low. The Vanguard 500 Index Fund, for example, has operating expenses of 0.18 percent of assets. Owners of index funds earn almost the market average, less the small operating expenses necessary to run the fund.

There is a second reason index funds are destined to perform better. They hold less cash than the typical actively managed fund, and therefore more of the fund is invested in the underlying securities. Over time, this makes a difference. In general, investors need to be invested in the market on a continuing basis, and not try to get in and out of the market based on their forecasts of likely market movements.

Insights

Market timing has been shown by a number of researchers not to work well. Although an investor or manager might sometimes make an astute call about when to get out of the market, it is much more difficult to determine when to get back in. Other studies show that if investors miss only a relatively few days or months of good performance over long periods of time, their performance will be dramatically impacted in a negative manner.

So, let's re- emphasize what we have already covered: Index funds tend to outperform actively managed funds because of their lower costs and because they hold less cash.

Think about the situation again. If we look back over the last six months, one year, three years , and so on, we see funds that outperformed the market. If we could be confident that these funds would continue to outperform the market our investing problems would be over. However, we can't. Most of these funds will revert to average or subaverage performance. Studies show that consistency in mutual fund performance does not persist.

Meanwhile, the index funds plod along, year after year returning almost what the market did, minus those very small expenses. Obviously, some years show a negative return, but these have been relatively few in the last 30 years. Overall, average market performance has been great, and if investors truly earned that average market performance they should be happy.

Let's consider what your odds are of doing better than average. The Wilshire 5000 Index (a misnomer because it actually includes about 6,600 stocks now) measures almost all of the U.S. stock market. It is the broadest market index we can observe. Assume at the end of the 1980s you bought the top 25 performing diversified U.S. stock funds. How many of these funds managed to beat the Wilshire Index in the 1990s? ^[2]

^[2] This example, and the next one, come from Jonathan Clements, "Getting Going," The News & Observer , July 15, 2001, p. 6E. Jonathan Clements writes "Getting Going" for The Wall Street Journal , an excellent source of informative investing information.

The answer, not surprising to believers in index funds, is eight; that is, two thirds of these funds failed to do as well as the broad market. If you sampled from these 25 funds in your purchases, you had only a one in three chance of picking a winner for that time period. Obviously, these are not very good odds!

What about bonds ? Investors can purchase the Vanguard Total Bond Market Index Fund that tracks the performance of a well-known bond market index called the Lehman Brothers Aggregate Total Bond Market Index. Consider the five-year period ending in 2000. Vanguard's index fund outperformed 95 percent of all high-quality taxable U.S. bond funds. Enough said here!

How popular are index funds? At the end of 2001, index funds constituted about 12 percent of all equity mutual fund assets. Investors clearly have not voted for index funds where it matters ”with their money. Instead, they continue to chase the managed funds. Why is that?

The reasons go back to what was covered in Chapter 7: The popular press is, probably inadvertently but nevertheless persistently, leading investors down the primrose path . Investors are constantly bombarded with the latest market news, with an emphasis on those stocks and mutual funds that have recently performed well, and with the promise that they, too, can build a winning investing strategy. Pick up the current issues of leading financial magazines and look at the lead stories ”you will see it over and over.

What does most of the professional investing community have to say about index funds? Not much nice, that's for sure. They claim index funds lead to mediocre results, but we now know that investors, on average, achieve average market results because they are the market. They claim index funds are undiversified, which is a silly claim at best. An index fund holding the S&P 500 stocks is much better diversified than most mutual funds, and by definition is as well diversified as the market as a whole (as measured by this index). They also claim that indexing does not work in inefficient markets. If you believe this one, look at the results for yourself at Morningstar. Because of higher expenses generated in investing in such areas as emerging markets, index funds will, on average, do better than the actively managed funds. The same is probably true for small-cap funds.

What is disturbing is that something seems to have been working in the past to lead investors away from index funds. As noted earlier, they constituted about 12 percent of all equity mutual fund assets at year end 2001. Many index funds have suffered net redemptions over some recent periods. This includes the granddaddy of them all, the Vanguard 500 Index Fund, which declined $30 billion in less than one year during the 2000 “2001 market decline.

How did the sharp market declines of 2000 and 2001 affect index funds? Interestingly, about 60 percent of the dollars invested in stock funds in 2001 went into an index product. ^[3] This might suggest that more and more investors are becoming persuaded about the merits of index funds.

^[3] See "In The Vanguard," Voyager Edition, The Vanguard Group, Winter 2002, p. 6.

So where does this leave us? Let's try to summarize:

1. The case against actively managed funds is quite strong. Too many investors are engaged in an ultimately doomed-to-failure pursuit of top-performing funds, led on by the popular press's never-ending cycle of promotional articles. Here is a sobering thought about professional mutual fund managers. The average domestic fund manager has only a little more than four years of experience. Thus, on average, shareholders are not retaining managers with years of experience who have seen various economic conditions and lived through, and survived portfolio-wise, various market movements.

2. Passively managed funds can build wealth over time at low cost. Index funds have several positive features, such as low costs, low turnover , and insurance against bad manager decisions.

3. Index funds do not address all the problems. Investors cannot buy and sell during the day with any mutual fund. NAV is determined once a day. Therefore, in fast-moving markets an investor cannot quickly change positions. Furthermore, taxes are not completely minimized because the market index mimics changes, and therefore the index fund has to change positions . This generates gains and losses. Some of the alternatives discussed earlier can provide investors with more exacting control over their tax situation.

Insights

Because we make a strong case here for the use of index funds, let's be perfectly clear about something: Not all index funds are created equal. You might reasonably assume that one index fund based on the S&P 500 Index is about as good as another index fund based on the S&P 500 Index because they both are trying to mimic this well-known standard. However, there can be big differences. Take, for example, the Wells Fargo Equity Index A shares. This mutual fund has a whopping 5.75 percent load charge. In contrast, as we have seen, the Vanguard 500 Index Fund has no sales charge. You really need to ask yourself if you are getting anything of value for giving up that much of your initial purchase for a sales fee. Maybe you are getting good advice from a broker or financial advisor and this is the price you pay, but you should really think long and hard about it. Furthermore, the indicated expense ratio is 0.71 percent, compared to an expense ratio for the Vanguard fund of 0.18 percent.

In my opinion, paying a large sales charge to buy a mutual fund pegged to the S&P 500 Index is probably not the craziest thing you could do, but it merits serious consideration.

Let's close this discussion with an interesting comparison of the two largest mutual funds in the United States at the end of 2001, Fidelity's Magellan Fund and Vanguard's Index 500 Trust. No one would recommend drawing all of one's conclusions from a sample of one comparison of two funds, but there are instructive points on using mutual funds effectively.

The Magellan Fund has been a very famous actively managed fund, known for its great performance over time. Particularly during the years when Peter Lynch managed it, this fund reported extraordinary performance. Vanguard's passively managed Index 500 Trust, in contrast, merely seeks to match the performance of the S&P 500 Index, year in and year out. Because it is an index fund, its annual expense ratio is very low. Like all Vanguard mutual funds, it is a no-load fund.

First, note that each fund shows the same objective based on its style box. Each is investing in large stocks, both value and growth.

The sales charge and annual operating expenses for the Magellan Fund are three percent and 0.88 percent, respectively. There is no sales charge for the S&P 500 Fund, and the annual operating expenses are 0.18 percent.

Figure 29-1 shows the performance of these funds over a recent 10-year period (ending on February 29, 2002), using the 10-year annualized return for each fund. It is assumed that $100,000 was invested in each fund at the beginning of the 10 years.

Figure 29-1. Performance of Magellan Fund versus Vanguard's Index Trust, 10-Year Period, Assuming Initial Investment of $100,000 in Each Fund.

Let's be clearly objective about this comparison. This is only one 10-year period, although of relevance is that it is the most recent 10-year period available at the time of writing. Another 10-year period could well show a different outcome.

Given this caveat, we have the two largest mutual funds by assets in the United States, both classified the same about their style. Magellan has been well regarded over many years, and rightly so. Yet, for the last 10 years, the Vanguard 500 Index Fund has outperformed the Magellan Fund although the latter was actively managed.

One of the obvious reasons for the difference in the two 10-year annualized performance numbers ”12.12 percent for the Magellan Fund and 12.53 percent for the Vanguard fund ”is the difference in annual operating expenses. Although Magellan's annual operating expense is very competitive at 0.88 percent, it can hardly compare to the incredibly low annual operating expense for the Vanguard fund of 0.18 percent. Over time, this makes a difference.

Finally, remember that had we placed $100,000 in the Magellan Fund, we would have given up money initially because of the sales charge. In contrast, our entire $100,000 would have gone to work in the Vanguard fund.