Chapter 30. If You Choose an Actively Managed Mutual Fund

Let's temporarily forget the fact that for the 10-year period ending mid-2000, only about one in four actively managed U.S. stock funds was able to outperform the market index as measured by the S&P 500. Let's forget that you could have owned an index fund that holds the S&P 500 stocks and has an operating cost of around 0.20 percent versus the average operating cost of the typical equity mutual fund of about 1.42 percent. After all, many of us think we are above average, and we can pick a good actively managed mutual fund ( myself included).

Of course, there are periods when stock pickers shine . One such period was early 2000 to early 2001, when most actively managed funds outperformed the S&P 500 Index on a trailing 12-month basis. Other such periods over the past can be identified.

Furthermore, there are some strong performers among actively managed funds. Consider the Legg Mason Value Trust, a well-known mutual fund managed by William Miller. Figure 30-1 shows the performance of this fund over the period from 1992 to 2001, plotted against the S&P 500 (the lower series in the graph). It assumes $10,000 was invested in each fund at the beginning of 1992. At the end of 2001, an investor in the S&P 500 would have $33,735, whereas an investor in the Legg Mason fund would have $53,044.

Figure 30-1. Performance of the Legg Mason Value Trust Fund versus the S&P 500 Index, Starting With $10,000 in Each Fund at the Beginning of 1992.

graphics/30fig01.gif

Clearly, the Legg Mason fund outperformed the S&P 500 Index during this period. Its risk, as measured by beta, is about 1.11, which most investors would probably view as quite reasonable given the fund's strong performance (the S&P 500 has a beta of 1.0, by definition).

The debate among investors and market observers about actively managed mutual funds versus passively managed index mutual funds goes on. Many people have opinions , and passions run strong. As we saw in the previous chapter, a strong case can be made for owning an index fund, but as we also saw, relatively few investors do so. If you are going to choose an actively managed fund, how should you go about making this choice?

First, know why you are buying a particular fund. This might sound like obvious advice, but many investors do not have clear reasons for their choices, or worse still, valid reasons. Are you responding to an ad you saw for a particular fund, touting its performance over some previous period of time? If so, think about what was said earlier about investors chasing performance, only to find they are buying at about the time the fund's performance is changing.

Are you investing in a particular fund because of the portfolio manager's reputation? This has made sense in certain cases ” certainly Peter Lynch of Magellan fame at Fidelity was a portfolio manager with an enviable record. But how many investors recognized this record in time to get on board the Magellan train?

If you are choosing an actively managed fund to obtain the services of a particular portfolio manager, you must be careful. In some cases, the same portfolio manager runs more than one fund, and the results are often quite different. Consider the following examples. [1]

[1] These examples are based on Jeffrey R. Kosnett, "Split Personality," Kiplinger's Magazine , March 2002, p. 52.

Kenneth Heebner is a well-known manager. In 2001 the CGM Focus Fund he manages returned 48 percent, whereas the market was down about 12 percent. However, he also managed the Capital Development Fund, which was down about 24 percent in the same year. Therefore, investing to obtain the services of a particular portfolio manager can be a tricky proposition.

Consider another example. Ron Baron manages both the Baron Growth Fund and the Baron Asset Fund. The former was up about 13 percent in 2001, whereas the latter was down about 10 percent. The Legg Mason Value Fund, run by Bill Miller, declined about nine percent in 2001, whereas his Opportunity Fund was up about two percent.

Investors can find considerable popular press information about various managers. They can learn about the managers' philosophy, their previous track record, and the tenure at their present job.

Investors should have realistic expectations concerning likely performance. A fund might have performed very well recently, but the odds are high that it will not continue to do so. Many investors are persuaded by stories told by their friends about the killings they made in some investment, or by a very good performance run by a fund. They convince themselves that such results are relatively commonplace and that it is relatively easy to achieve such results. They then form unrealistic expectations about the level of returns they can expect to earn, or worse, that they are entitled to.

Let's step back for a moment and gain some perspective on financial asset returns. There are numerous market measures and indexes, and obviously results can be measured over various periods of time. To measure stock returns, we concentrate here on the historical results for the S&P 500 Index, arguably the most important and often-used measure of the performance of large, well-known common stocks. This index is generally the index of choice for institutional investors unless they are holding portfolios of foreign securities, small securities, or some specialized group of stocks or market sector.

We have good rate of return data back for many years ”actually to 1871, although the data generally get less comparable as we go back in time ”so consider a very long period of time starting in 1920 and going through 2000. We can consider rate of return data for common stocks (the S&P 500 Index), Treasury bonds, corporate bonds , and Treasury bills.

The data we consider here are in the form of average annual compound rates of return over this long period. In other words, if you had invested $1 in 1920 (or any other amount you choose), how many dollars would you have at the end of 2000? This result would be based on the numbers shown in Table 30-1, the compound annual average rate of return.

Table 30-1. 1920 “2000 Compound Annual Average Rates of Return

S&P 500 Index

10.82%

15-year Treasury bonds

5.25

Corporate bonds

5.84

Treasury bills

4.06

With these actual results we can gain a much better perspective about expectations. No one can predict the future, and rates of return could turn out to be different than they have been in the past. However, there is currently no evidence to suggest that this will be the case. Therefore, we have to rely heavily on historical rates of return. After all, this long period encompasses wars, depression, tremendous growth, significant inflation, and so forth.

As we can see, the S&P 500 has grown at an average annual compound rate of return of approximately 11 percent over a very long period of time. Therefore, if you as an investor buy a mutual fund holding large common stocks and expect your investment to compound over time at 20 or 30 percent, good luck. It might do so for relatively short periods ”after all, the five-year period between 1995 and 1999 saw rates of return in excess of 20 percent for each of those years. However, it won't happen all that often, and we all know what followed those great returns for those five years ”the sharp market losses of 2000 and 2001.

Next, look at the costs of buying and owning the mutual fund you have in mind. Do you really want to pay a sales charge? Only about 30 percent of mutual fund assets are in no-load shares, so clearly the majority of investors have opted for funds with sales charges.

Investors in actively managed funds need to realize the trend that is going on in this area today. There is a big consolidation movement in the industry, with large firms buying up independent funds. A number of these large firms have brokerage firms, which in turn have large sales forces that must be compensated. Thus, there is a trend to convert previously no-load funds to load funds. Among the funds making the switch from no-load to load are Pilgrim, Invesco, Acorn, and Lexington. Once again, intelligent investors need to ask themselves if buying shares in a load fund is really what they want to do. There are good actively managed no-load funds.

The annual operating costs of various actively managed funds vary widely. You can make an argument that paying reasonable costs for strong performance is a good strategy. It is, as long as you receive strong performance and come out ahead of the alternatives with lower costs.

Now, do some careful thinking about your tax situation in general, and in particular investigate any actively managed fund you are considering to determine the fund's tax implications. Is it particularly important for you to own a tax-efficient fund that will pay careful attention to its distributions? Can most actively managed funds match the performance of index funds in this regard?

How should you go about choosing an actively managed fund? As we know, a tremendous amount of information is available in the popular press and on countless Web sites. After we consider why we are buying a fund, analyze its costs and its tax implications, what's left? We know how funds have performed, so is that helpful?

A couple of observations are in order when considering a fund's performance record:

  1. If it has had really poor results, there is a good chance that such results could continue into the future. Avoid these funds.

  2. Good results are a starting point. Based on these results you can do additional research into the fund. Does the manager really have an edge? How long has the manager been on board? Is there turmoil at the organization, which seems to have been the case at Janus in recent years?

Finally, maybe you should consider the timing of your transaction in terms of buying an actively managed mutual fund. Although market timing in general has been found to be both very difficult to accomplish successfully and not rewarding to the average investor, it might nevertheless be useful to consider some probabilities.

Insights

If you are going to hold mutual funds in tax-deferred accounts, try to find managers who have the best performance records, regardless of trading activity. Such managers typically act to take advantage of any situations they find, without regard to the taxable implications. In contrast, if you plan to hold the mutual funds in taxable accounts, it generally pays to be concerned with the tax efficiency of the fund. After all, what matters is what you as the investor get to keep, not what the manager earned on a pretax basis.

There is evidence to suggest that manager tenure matters ”how long a particular manager has operated a fund. Of a small set of funds that were identified as doing particularly well over a recent 10-year period, the average tenure was more than 10 years, compared to just over four years for the average equity fund manager. Experience seems to pay off. Other things being equal, you want a manager who has been through bad market periods as well as good market periods, and who has experienced a variety of situations.

A recent research study by Morgan Stanley Dean Witter, subsequently confirmed by Bloomberg Personal Finance , indicates that for the period January 1985 through January 2001, [2] when small-cap stocks (as measured by the Russell 2000 Index) outperformed the S&P 500 Index, more than 50 percent of actively managed domestic equity mutual funds did better than the S&P 500 Index. [3] The Russell 2000 is a well-known index of small-cap stocks, reported daily in The Wall Street Journal and other sources. It is widely regarded as a benchmark measure of small-cap stocks. When large caps are outperforming small caps, less than 50 percent of actively managed funds did better than the S&P 500 Index.

[2] This discussion is based on James Picerno, "Stock Pickers on Top," Bloomberg Personal Finance , May 2001, pp. 25 “27.

[3] Small cap refers to the market capitalization for a stock ”price multiplied by number of shares. In contrast, stocks in the S&P 500 would be referred to as large-cap stocks because their total market value (price multiplied by number of shares) is very large.

What does this mean on a practical basis to investors willing to purchase actively managed funds or pursue active strategies? It means you need to pay close attention to the markets and try to determine if small stocks or large stocks are currently doing better, and what the outlook is for each. If small stocks are currently on the rise, it might be a good time to choose actively managed funds.



Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
Mutual Funds(c) Your Money, Your Choice... Take Control Now and Build Wealth Wisely 2002
ISBN: N/A
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Year: 2004
Pages: 94

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