Wall Street has abandoned the mutual fund. The financial instrument that brought investors the great bull market of 1982-1999 is losing ground to other investment products. After New York’s Attorney General, Elliott Spitzer, began highlighting wrongdoing by a number of large marketing oriented firms, the popularity of mutual funds declined precipitously. A cottage industry emerged to bash funds and promote the distribution of other, generally more expensive, alternatives. As a result, investors are flocking to separately managed accounts, exchange traded funds, hedge funds, and annuities. In doing so, many investors may be making a mistake.
The Financial Research Corporation tracks new product sales growth for the financial industry. FRC’s September 2005 newsletter projects that mutual fund sales will grow at a 6% rate each year for the next five years. Hedge fund sales are projected to grow 17% a year, separately managed accounts (sometimes called wrap accounts) are growing at an 18% clip, and Exchange Traded Funds are growing at an eye popping rate of 32%.
It is unorthodox to suggest that the old fashioned actively managed mutual fund is still the best investment tool for most individuals, but there is logical support for this investment heresy. Investors who choose their mutual fund using a disciplined review process similar to what they should be using to choose their investment advisor will find many good funds in which to invest. In fact, given their public track records and wealth of information available on mutual funds, it’s probably easier to choose a fund than it is to pick your advisor!
There are over 9,000 funds focused on domestic stocks. Though the rule of thumb says that 8 out of 10 mutual funds underperform their index, reality is somewhat different. Over the past five years, over 49% of the funds in Morningstar’s domestic stock fund universe have outperformed the Vanguard Total Market Index Fund (which has trounced the more popular S&P 500 Index Fund). True, there is a survivorship bias represented since poorly performing funds are closed which skews these numbers a bit. But the traditional slam against active management, that your choice of funds doesn’t matter because almost all funds underperform, has little basis in reality. Even after fund expenses, and trading commissions, and bid-ask spread transactions costs, the net result to clients for many funds is that they beat a passive management (index) strategy.
Financial orthodoxy also says that it is impossible to distinguish the good money managers from the lucky ones and that fund outperformance is merely a matter of random selection. Then, having persuaded investors to sell their lower cost mutual funds, salesmen take a contradictory position that it is, somehow, possible – given their thorough due diligence process – to pick outstanding separate account managers instead. It is no coincidence that wrap account fees are typically higher than that of a typical mutual fund. How can advisors be adept a picking separate account managers, yet somehow incapable of identifying solid mutual fund managers, especially when many of the wrap managers already offer nearly identical investment approaches through lower cost traditional mutual funds? There is much less data available for wrap managers, track records are shorter, and manager performance composites are less accurate – so actual investor performance is essentially unknown. What generally happens is that advisors follow the time honored tradition of chasing the hot manager (rearview mirror investing), an approach which often backfires leaving investors more frustrated than ever.
These are not really custom managed portfolios, but essentially mutual funds in drag. One of the primary benefits of owning the individual stocks in a separately managed wrap account that advisors tout is the tax benefit of owning individual securities, yet a 2002 Cerulli Associates study showed that only 30% of taxable accounts take advantage of the ability to harvest tax losses in client accounts. And don’t expect your advisor to recommend these tax saving strategies. Over 75% of the tax sales were initiated by clients, not their advisor or the sub-advisor chosen to manage the account. In some instances, a stock sold at year-end for tax planning may not be repurchased until months later when a computer automatically rebalances the portfolio. Furthermore, no one is bothering to monitor whether clients are selling losers when they’re down, and repurchasing them at potentially higher prices in 31 days, or not. Is tax harvesting really adding any value to client portfolios – or just converting a potential long-term gain into a short-term gain during the following tax year and making the client feel like they’re better off, even when that’s not the case.
Managing money is, frankly, rather messy. Like making sausage, sometimes investors would do well not to see the day-to-day transactions. Great fund managers were belittled and abused in 1999 for not jumping onto the internet bandwagon by inexperienced fund holders who were watching the market just a little too closely. Those who refused to abandoned their valuation disciplines, or who bought real estate while others flocked to the technology sector, were quite unpopular at the time. In the end, however, investors who hired an experienced active manager to pick their stocks for them and then went back to ignoring the markets’ gyrations did far better than the day traders and CNBC addicts who inserted themselves into the sausage making process and lived to regret the experience.
So what approach should investors choose? There is nothing wrong with the conservative approach of indexing. It at least guarantees investors market returns without overly committing them to supporting Wall Street’s excessive compensation habits. On the other hand, good investment managers pay for themselves. Selecting an experienced investment manager with a reasonable probability of outperforming the market over the market cycle (which makes their services “free”) just takes remembering a few rules and doing a little bit of research.
1) Using data on Morningstar.com, include only funds with solid long-term track records in your search. However, forget about picking a manager based on the “best” 5-year track record. Some of those top-performing funds will revert to the mean and be on the “worst” list over the next 5 years. Buying the “best” in 1999 was essentially a guarantee that the investor would lose a great deal of money when the bubble burst. It does, however, make sense to start with a list of funds that have outperformed the market, though. But that’s just the beginning.
2) Filter out one-decision funds that are on the list because of one good year. Van Wagoner Emerging Growth Fund, for example, rocketed to the top of the charts with performance that was 270% ahead of the market in 1999. Yet the fund had underperformed significantly in the prior two years, and had barely outperformed the market the year before that. The manager made one decision (jump on the tech bandwagon) to get to the top of the list. A better choice would be a fund lower on the list that had outperformed, by a lesser amount, in four out of five of the previous years. Narrow your search to 20 to 30 funds, and then start reading. You might want to form an ad hoc club and share your results with others. It will reduce your burden and give you some alternative perspectives. Though it is not a “committee” decision, good choices are rarely made in a vacuum.
3) Look for funds that employ a disciplined and fairly straightforward investment process. If you get the sense in manager interviews that the manager is knee-deep in hogwash and flinging jargon and rationalizations faster than a 30-second campaign ad the day before an election, chances are that you are right! An embarrassing number of portfolio managers tout the depth of their research staff, impress you with the total dollar of assets in their fund, spout nonsense and get away with it. But managers who know their companies well tend to bring detailed, special knowledge to the table. Stick with either “quant funds” where a computer does all the decision-making and the portfolio is broadly diversified, or with funds where the manager-speak has a low bunk quotient.
4) Look for flexible funds where managers can “go anywhere” to make money. Many brokers and most pension consultants hate these funds. Critics warn about “style drift” where a formerly large cap growth oriented fund shifts gears to invest in small cap value companies instead. But isn’t that what you wanted your all-star manager to do in 1999? Most successful money managers couldn’t care less about style drift. They just want to make money! If the best opportunities lie in the growth sector, then that’s where they want to be. If you are hiring a professional to take advantage of the best opportunities in the market, why would you want to constrain their stock universe? If you choose your fund manager the same way you would rationally choose an investment manager, you want them to consider a broad range of investment alternatives and you want to give them flexibility to implement the best investment strategy given the current economic environment.
5) Choose managers that demonstrate appropriate non-investment behavior. More than one good fund complex has been ruined by putting a marketing person at the top. The best fund managers didn’t want the business of hedge fund market timers because it hurt long-term fund investors. Furthermore, the best fund managers are often heavily invested in their own funds, and don’t want to adopt foolish or costly practices that take money from their own wallet. Many of these managers invest primarily for wealth management or pension fund clients, and just offer funds as a low-dollar entry point for less affluent investors. There is no way that they want to compromise their track record nor their reputation for what tiny bit of extra revenue they might receive for accommodating a market timer. It pretty much takes a “marketing genius” to make that mistake. Though all managers want to boost assets under management, not all managers place that as their top priority. Look for managers who are obsessed with delivering great performance, because some of these folks actually have the skill and discipline to deliver what you seek.
Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.
Posts
