Smaller Fund Outperformance – It’s Not Just Mutual Funds
The bigger a mutual fund gets, the harder it is to outperform. This relationship is why we created our “Fat Fund Index” back in 1999. As it turns out, managing too much money hurts other types of investment portfolios as well.
According to a segment on CNBC this morning, Thomson Financial did a study showing that private equity returns over the last 15 years have run an average of 15.9% a year for smaller funds (less than $1 billion under management) compared to just 11.6% a year for larger funds (over $1 billion). For private equity funds that specialize in startups – venture capital funds – the outperformance is even greater: 23.1% vs. 15.5%. Private equity funds are funds with fewer restrictions on their investments and catering to institutional and high net worth investors – those that the SEC thinks can look out for themselves.
Mutual funds invest almost exclusively in the stocks of publicly traded companies, which tend to move as a group. Private equity funds often take stakes in private business – ones that do not sell shares to the public. The private equity funds that invest in startups see the biggest performance boost from being small because they can invest in smaller startups that have the biggest upside potential. Apparently giant funds have had to pass on too many good small deals.
For mutual funds the benefit of being small also increases as fund managers look to smaller companies to buy. Having $2 billion under management may not hurt a fund that invests in U.S. large cap stocks, but it can be a big drag for small cap or emerging market oriented funds.
Our Fat Fund Index (available on most fund data pages here on MAXfunds.com) adjust for this moving target issue. Check a few of your favorite ticker symbols in our fund-o-matic and see for yourself.
Prep Your Portfolio
Marketwatch lists five no-load mutual funds experts say will be good vehicles for saving for a child's private high school tuition. The criteria they've chosen for the list are low fee, high performing funds suitable for investors with a relatively short investment horizon.
- Vanguard Intermediate Term Bond Fund
- Loomis Sayles Bond Fund
- Oakmark Global Fund
- Dodge & Cox International Stock Fund
- Vanguard LifeStrategy Conservative Growth Fund
Our take: Investing 100% of a portfolio that needs to be tapped within ten years in stocks is a bad idea. Two of the funds on this list – Dodge & Cox International Stock and Oakmark Global can fall up to 50% in a very bad market for stocks, with 25% pullbacks relatively common.
Another word of caution: today it is fashionable to point to international and global funds as the top choices for a portfolio. A few years ago, most would have gone with U.S. large cap growth or tech funds. Dodge & Cox International Stock has been on our favorite funds list (part of our Powerfund Portfolios service) for international funds since 2002 – when we started the list. However, with such widespread popularity today (and tens of billions in relatively recent new assets) resulting from a five year return of around 150%, investors looking to move money to such a fund could be making a similar mistake investors made in 2000 piling into hot Janus funds.
Note that Oakmark Global has a 2% redemption fee if sold within 60 days. For new investors, Oakmark Global can only be purchased directly from the fund company.
For Most, Index Funds Beat ETFs
We’ve said for years that plain vanilla index funds are better than exchange traded funds (ETFs) for most fund investors, and a recent Wall Street Journal article confirms this view.
"Newly crunched data show it is a close race -- but ultra-low-cost conventional index funds outperform ETFs a lot more often than not."
As the table below shows, ETFs often slightly underperform regular index funds.
The article notes the comparison doesn’t even take commissions into consideration – an important cost you avoid buying a plain vanilla index fund directly from the fund.
The article also doesn’t note another cost of choosing ETFs: the spread. Somebody makes money when you buy and sell a stock or ETF (in addition to ordinary commissions). Buy an ETF and sell it a few seconds later, and you will lose money beyond the commissions most of the time.
The article debunks another much-ballyhooed benefit of ETFs: tax efficiency. ETFs are not more tax efficient than low fee index funds.
The financial press is fond of comparing ETFs to ordinary actively managed mutual funds, making them look in the comparison – Suze Orman is particularly guilty of this one. Actively managed mutual funds are higher fee and more tax inefficient – and they compare just as poorly to ordinary index funds as they do to ETFs.
Bottom line, ETFs can be the right choice if you trade frequently, prefer the convenience of owning all your investments in a brokerage account, or when there is no comparable traditional index mutual fund (as is increasingly the case with the newfangled ETFs that aim for more specific strategies).
LINK (Registration required.)
No Fat Funds
We've been singing this song for years: asset bloat is one of the leading causes of fund underperformance. But does anybody listen? Of course now that Mr. Big-Time-Bloomberg-Mutual-Fund-Columnist Chet Currier follows our lead , everybody will think it's a brilliant concept:
It's one thing to rack up nice returns when a strategy is new and the amount under management is small. The job may prove different after those early gains attract heaps of additional money from investors, and the fund that used to maneuver like a sports car comes more and more to resemble a dump truck.
'Asset bloat' is the term analysts at the Chicago firm of Morningstar Inc. use in their mutual-fund research.
'The worst effect of the asset bloat phenomenon is simple,' Morningstar says. 'The more money a fund has in it, the less nimble it becomes. If a fund's asset base increases too much, its character necessarily changes.'
Some fast-growing funds close to new investors to try to mitigate this effect. Others resist any such move, insisting they can handle the extra load.
Closings don't always solve the problem anyway, especially if a fund leaves its doors open to additional investments by retirement-plan members or to all clients of brokers and advisers who have existing accounts. The damage may not be immediately visible to the casual onlooker."
It would be great if some mutual fund research website would come up with a simple data point that would reveal how bloated with assets each mutual fund was. Call it a 'Fat Fund Index', if you will. Hey, we've been doing that since 1999!
MAXfund's Fat Fund Index lets you know if a fund is weighted down by its own heft. A FFI of 1 means a fund is lean a mean and will suffer no drag on performance because of asset bloat. A fund with an FFI of 5 is fatter than Homer Simpson and could suffer serious performance issues in the months ahead. You'll find each fund's Fat Fund Index on MAXfunds' recently redesigned data pages.
MAX on Fox News
MAXfunds.com co-founder Jonas Ferris predicts big declines in condo prices and lays out some mutual fund strategies you can employ to profit from those declines. In the video Ferris discusses the faulty logic of ‘investing’ $1,000 into home renovations and generating $3,000 or more of instant value added. It’s a video you won’t want to miss, unless you are a producer of “Flip This House”.
MAXadvisor Powerfund Portolios Update
Note to subscribers of the MAXadvisor Powerfund Portfolios: this month's portfolio performance data update and commentary has been posted. Subscribers can log in by clicking here.
The MAXadvisor Powerfund Portfolios is a collection of seven model mutual fund portfolios ranging in risk from very safe to quite aggressive. Each portfolio is made up of a group of terrific, no-load, low-cost mutual funds that are carefully chosen to work together to lower volatility and increase returns. You can learn more about the MAXadvisor Powerfund Portfolios (and sign up for a free trial if you like what you see) by clicking here. ...read the rest of this article»
Green Stocks Too Hot?
Marketwatch reports that so-called "green" stocks, the underlying investments of environmentally-focused socially responsible funds, could be heading into speculative bubble territory.
'It was just a year ago where we would have somebody arguing with us over whether or not the market would ever favor green investing,' says Jack Robinson, co-manager with Matt Patsky of the Winslow Green Growth Fund. "What a difference a year makes.'
Indeed, some green fund managers now see the share prices of many companies tied to environmental sustainability as, well, unsustainable. 'Now you've got to worry about valuation and some of the speculative bubbles that are building,' Robinson says.
'I'm certainly concerned that you have too much hot money moving in,' says Eric Becker, co-manager of the Green Century Balanced Fund , which keeps about two-thirds of its portfolio in stocks and the rest in bonds. 'There are investors who are going to get burned.'"
We feel investor exuberance (and lack thereof) is a key factor in investing decisions. There are many ways to keep tabs on how overblown an investing idea is. Initial public offering volume and excitement is one indicator, as is rising prices and investor enthusiasm.
However, just because a few stocks go public and a few others rise does not mean the party is over. We consider fund investor behavior to be a little more indicative of bubbles and future bad performance than hot stock performance in an area. On each fund data page on MAXfunds.com, you will see our “Hot Money Index” which measures how much money is flooding into a fund. We also measure hot money across all funds in a fund category.
You'll note that many of these green funds do not have much hot money, meaning they are not bringing in the hundreds of millions (and sometimes billions) of new cash we often see before an area stalls or worse, crashes. But before jumping to the conclusion that this means there is much more upside here, be aware that most of this sort of “trendy” money these days goes into ETFs, not old fashioned open end funds.
While the typical fund investor hasn’t put many chips on the alternative energy table in open end funds in the last year, ETFs have had more success. We now have new ETFs like PowerShares WilderHill Progressive Energy (PUW) and PowerShares Wilder Clean Energy Portfolio (PBW). The later is tipping the scales at around a billion dollars, pretty big money for a gimmicky new fund. New fund launches are another negative sign – fund companies tend to launch new funds near the top not near the bottom of any cycle. PBW has brought in more than ten times what the newest open end alternative energy fund has brought in – Guinness Atkinson Alternative Energy (GAAEX) - even though this open end fund has performed better than the ETF.
Bottom line, if you look just at open end funds, we have more to go in this speculative area. When you bring in ETFs, we look a lot closer to the top in alternative energy stocks.
Green funds mentioned in the article:
Winslow Green Growth Fd (WGGFX)
Sierra Club Stock Fund Inv (SCFSX)
Resist the Urges
Morningstar's Fund Spy lists three critical investing mistakes to avoid:
Don't read too much into the recent past - Instead of doing the necessary and possibly tedious homework to research a potential investment, investors "anchor" their expectations for the future in the recent past.
The problem, of course, is that yesterday doesn't always tell you what tomorrow will bring. If you don't believe us, just ask investors who swarmed red-hot technology- and Internet-focused stocks in 1999 and 2000 expecting the good times to continue. They didn't, and most folks ended up suffering huge losses.
You don't know as much as you think - We think we're more capable and smarter than we really are. As an investor, you should check your excessive optimism at the door. You might believe you're more likely than the next guy to spot the next Microsoft, but the odds are you're not.
Keep winners longer and dump losers sooner - (Behavioral-finance) noticed that investors would rather accept smaller but certain gains than take their chances to make more money. On the flip side, investors are reluctant to admit defeat and sell stocks that are underwater in hopes of a rebound. As a result, investors tend to sell their winners too early and hang on to their losers for too long."
And as long as you're in an investing-rules-list-reading kind of mood, take a gander at our oldy but goodie (circa 2000) Seven Golden Rules of Mutual Fund Investing. Note that fund data pages have changed since then - please review current definitions of metrics by rolling over the terms on our new data pages.
12b-1 Fees Gone Wild
John Waggoner at USA Today looks at the wacky past and current state of affairs of the oddly-named mutual fund 12b-1 fee.
The American Funds' Growth Fund of America A, for example, which is the nation's largest fund, weighing in at $85 billion in assets, doesn't exactly need to jack up its marketing efforts to attract more assets. Yet that fund charges a 12b-1 fee of 0.25% — nearly as much as its other fees combined. The American Funds says the fee goes to servicing accounts.
The 12b-1 fee is also at the heart of the bewildering multishare class system we have today. In many cases, 12b-1 fees have morphed into a way to indirectly pay a broker's commission.
Funds discovered that people don't like to pay commissions on mutual funds. So they used the 12b-1 fee to make the brokerage charges more palatable and less transparent.
A particular mutual fund might have three share classes. Each share class represents the same portfolio but has a different expense structure."
For those looking for a brief history into the nature and causes of mutual fund 12b-1 Fees, it’s a must read.
An interesting factoid from the article: the entire mutual fund business had less money in total assets in 1980 than in 1972. Now THAT’S a rough market environment. No wonder everybody was buying gold – they plum gave up on stocks ( gold is still down from 1980 and stocks are up well over 20-fold). Today total mutual fund assets are much higher than the market peak of 2000 - even though the S&P 500 just broke its old record set in 2000. Fund investors are just more forgiving these days.
More startling, American Funds Growth Fund Of America Class A (AGTHX) alone has more money in it today than the entire fund business was managing back in 1980.
Morningstar Picks – No Better Than Dartboard?
Fund ratings giant Morningstar recently released its quarterly list of fund analyst picks, and the results are disturbing.
When it comes to picking domestic stock funds, Morningstar’s analysts – professionals armed with boatloads of data and all-access passes to fund managers – actually do worse than the average investor casually picking index funds, and they seem to do no better in some fund categories than the same investor throwing darts. The implications for casual individual investors are startling.
Last quarter, we noted that their “batting average” was only slightly better than your standard dart-thrower and worse than buying index funds, but when their picks are parsed into different fund groupings, the numbers are surprisingly poor, and highlight how difficult fund picking can be, even for the experts
"...our five-year average was 65%. That means that our picks have been winners about two thirds of the time over the past three and five-year periods. We think that's solid."
As we’ve noted before, index funds generally beat their fund category average over 65% of the time. But even this measure of success belies the trouble picking funds in the key area of domestic stock funds – which is where most investors maintain the bulk of their fund holdings. Morningstar now sheds a little light on this issue:
"It's interesting to note that by asset class, the weighted batting averages show our picks have been more successful in foreign stocks, municipal bonds, and taxable bonds, and less so with domestic equity. For example, 98% of our foreign large-blend picks have been winners over the past five years, while just 50% of our domestic large-blend picks have been winners."
50% is pathetic. Any dart-thrower could expect to beat the large-blend fund category average (not the benchmark index) at least 50% of the time (half would beat, half would lose).
Morningstar does not detail their performance in other domestic stock fund categories like small-cap and mid-cap value, growth, and blend. They do state the following, however:
"Using the aggregate measure, our domestic-equity picks (excluding sector funds) returned 9.56% versus 7.76% for the Wilshire 5000 and 6.27% for the S&P 500. We're pleased with those figures, too, but recognize that market-cap bias has a hand in that success."
Market-cap bias had more than a hand in it. Fund investors may not realize just how badly large-cap growth funds have performed in comparison to other fund categories in recent years.
At the end of the first quarter of 2007, looking at the past five years (2002-2007), the ONLY fund category that underperformed the S&P 500 was large-cap growth (ironically, this is the fund category where most domestic five-star funds could be found back in 2000 before Morningstar adjusted their ratings system to look at performance in category as opposed to performance against all domestic stock funds). The large-cap blend funds' performance nearly tied with the S&P 500 in a dead heat. In other words, the dartboard fund pick from each domestic fund category (there are nine) had a 77% chance of beating the S&P 500. Five out of nine domestic stock fund categories beat the market cap-weighted Wilshire 5000. If you'd matched the domestic stock fund category averages over the past five years, you'd have beaten the Wilshire 5000.
Sometimes it's very easy to pick winners in a certain category. Bond-fund picking is all about expense ratio. There are scores of bond funds out there with total expense ratios (including 12b-1 fees) over 1%. How in the world are these funds going to perform well with bond yields around 5%? As Morningstar notes,
"In bondland, we've enjoyed a lot of success in core categories such as intermediate bond and muni national long where our batting averages are more than 90%."
As the performance of large-cap stocks improves, it will become even more difficult for fund picks to beat benchmark indexes. The typical stock fund has an average market cap lower than a market cap-weighted benchmark index.
Bottom line - picking winning funds is at best difficult, and often a total crapshoot. Many investors and even Morningstar analysts are too easily swayed by good past performance. They ignore or downplay expenses, fund asset size, reversion to the mean, and plain old luck. The vast majority of investors (and those that choose funds for 401(k) plans) should just go with index funds – if they do, they’ll probably beat Morningstar's analysts.