Wednesday, January 18, 2012

Picking A Mutual Fund: The Madness of Crowds

I was reviewing the New York Times mutual fund performance tables, which are based on Morningstar performance numbers, and then I went to Smart Money and used their screen to find the "best" Large Cap Core equity funds, based on one-year performance.  I hardly recognized any of the funds.

There are some well demonstrated propositions about mutual funds and about retail investor behavior:

  • Most mutual fund managers under perform their indexes, with the number ranging from 60-70%, depending on the study.
  • The top performing asset class (high yield bonds, Treasuries, large cap equities) in a given year generally doesn't show up as the top performer in the following year.  Even with randomness in returns, runs of top performance do occur, as with international equities were the top performaing asset class from 2004-2007.  As they say in the boiler plate mutual fund disclosures, "Past performance is no guide to future performance." 
  • All things equal, it's immensely more difficult to achieve stellar performance with a jumbo pool of assets than with a small pool of assets, assuming the manager stays within investment policy guidelines. 
With these in mind, it's also well established that:
  • Retail investors rarely know why they are buying an individual mutual fund, and they almost never look at an asset class in the context of their total portfolio risk and return.
  • Since they don't know why they bought a fund, they usually sell when there is a period of under performance relative to the market, even though their fund manager might be pursuing a proven, consistent strategy which historically wins over time.
  • When they sell, they chase performance and pile like lemmings into the hot performing mutual fund based on historical, not expected returns.  This is what happened with the Fairholme fund.  
  • So, individual investors sabotage themselves and benefit only their brokers with high turnover, usually incurring fees.  
Over past five years, the market, as measured by the Fidelity Spartan 500 Index Institutional Class fund, was up 0.20%, the benchmark for large capitalization funds.  The Fairholme fund was up 0.30% over the five years, with assets of $6.9 billion, according to the Morningstar data reported in the NY Times. 

The American Funds Growth Fund of America, with $53.2 billion in assets, a popular large cap offering in defined contribution plans, turned in a comparatively lackluster performance, gaining 0.1% per annum over the five years, despite having experienced managers, a consistent philosophy, and a good infrastructure to support the investment process.  

The Dodge and Cox Stock Fund is also a fund that I've used in corporate plans as well as in SEP plans: it posted an absolutely dismal -3.30% per annum loss over the trailing five years compared to a broad market which averaged 0.2% per annum over the same period; the fund had $36.6 billion of assets managed in the strategy.  We've talked about the firm in other posts, noting that their funds have low expenses, long management tenure, a very consistent investment valuation process, a value orientation, very low turnover, and the lion's share of partner assets invested in Dodge and Cox funds. These are all critical factors for me as a personal or institutional investor.  Even so, mistakes happen or the index's performance itself can diverge from fundamentals; the five and three year performance numbers are not good.  With this kind of fund and others, if an investor believes that the strategy, portfolio management, valuation process, and corporate culture are still consistent and robust, then the poor historical performance may be a good buying opportunity looking forward.  This is the opposite approach to chasing performance.

If an investor were chasing performance in the large cap core equity fund, a good choice might be Sequoia, which we've written about before also.  The fund's average annual rate of increase was 4.30% for the past five years, with $4.9 billion under management.  The fund, which had high cash levels for several years, finally redeployed much of the cash and diversified the portfolio; however, the formerly large cash position had insulated the fund's relative returns during the financial meltdown, which in turn helped attract yet another huge inflow of investor cash, giving the portfolio managers a new challenge in how to reconfigure the portfolio from here.  Ruane, Cunniff and Goldfarb, the investment management company, have a long and distinguished track record, and they'll figure it out to the benefit of shareholders.  

Fidelity had two funds worth noting, for different reasons.  Magellan, which was the original mutual fund darling of the financial press from Peter Lynch's tenure, returned -2.70% per annum for the five years, with $12.9 billion in assets.  This fund, once the core of Fidelity's offerings, has gone through too many manager changes, along with significant instability in the portfolio strategy, design and investment process.  NYU Stern's Antti Petajisto, used a measure called "active share" to identify fund managers he called "closet indexers,"  who charged high fees in relation to index funds for essentially mimicking the index.  Magellan under a previous manager had been a closet indexer for several years, a far cry from its history as a growth fund with a value orientation and strong stock selection.  

On the other hand, Fidelity's Contrafund returned an average of 2.80% per year over the five year period, compared to 0.20% for the Standard and Poor's Index.  Remarkably, it did this on an asset base of $54.7 billion, with the portfolio manager Will Danoff probably managing around $100 billion in total assets for Fidelity.  Will Danoff was a great analyst who became a stellar portfolio manager.  He clearly can develop and deploy a strong supporting team of analysts and portfolio managers to help him deliver results with the appropriate level of risk.  This is way too much money to manage with a "Lone Ranger" approach used by managers we've all read about.   The cultural problem at Fidelity seems to be that success or mediocrity with a fund seems to rest less with Fidelity's organizational strength and culture than with the abilities of the individual managers.  This makes it tough for the individual investor, especially the trend driven one.  

disclaimer: Nothing in this post should be construed as investment advice or as a recommendation to buy or sell a particular fund or family of funds.  I have recently taken a small position in DODGX, but do not have a position in any of the other funds mentioned in the post. 

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