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My Search for the Worst Mutual Fund Yielded a Surprising Result

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I wanted find the worst performing actively managed Large Cap Blend style mutual fund in Morningstar’s data base over the five year period ended October 31, 2012.

English: Legg Mason Tower, Legg Mason Headquaters

I was surprised to find that the fund was Legg Mason Value Trust which until earlier this year had been managed by legendary fund manager Bill Miller.  The fund has several share classes, for this analysis I used the I share class (ticker LMNVX).

Bill Miller is a legendary fund manager because he was able to beat the return of the S&P 500 Index each year over a 15 year stretch from 1991-2005.  This is an incredible feat of performance and consistency.

How did this fund end up at the bottom of the rankings?  Starting with 2006, the fund underperformed the index each year except 2009.  Let’s look at the fund’s performance over the past 10 + years:

Year Fund Return S&P 500 Return Category Avg. Return Fund Rank in Category
2002

-18.06%

-22.10%

-22.25%

13

2003

44.99%

28.68%

27.05%

1

2004

13.09%

10.88%

10.02%

14

2005

6.36%

4.91%

5.88%

40

2006

6.92%

15.79%

14.17%

98

2007

-5.73%

5.49%

6.16%

98

2008

-54.61%

-37.00

-37.39%

99

2009

41.96%

26.46%

28.17%

6

2010

7.71%

15.06%

14.01%

96

2011

-2.99%

2.11%

-1.27%

70

2012 YTD

7.72%

10.29%

8.86%

71

Via Morningstar as of 11/16/2012

In terms of category rank, 1 is the top of the category, 100 would equal the bottom.  This fund ranks in the 99th percentile of the Large Blend category for the five years ended October 31, 2012 (there was actually one fund ranked lower but it was a bit of a specialty fund so I eliminated it).

What happened to Legg Mason Value Trust?

What happened to this high flier?  While I’ve never invested either my own money or any client money in this fund, here are a couple thoughts:

The fund’s assets peaked at just under $7 billion in 2006, fund assets stood at about $328 million as of October of this year.  I’m guessing that as performance continued to slide, investors continued to redeem their shares.  The need for liquidity to meet these redemptions has most certainly been a drag on the fund’s performance.

In 2002 the S&P 500 lost over 22%; the fund was able to limit its loss to just over 18%.  In 2008 the S&P 500 lost 37% while the fund lost an astonishing 54.61%!  That means that an investor with $10,000 in the fund on January 1, 2008 saw their holdings drop to $4,539 by the end of 2008.  The value-oriented approach that had served shareholders well over the years was in the process of producing a third straight year of the fund performing in the category’s bottom 2%.

Lessons in Picking a Mutual Fund

Many argue that no active fund manager can continually outperform the markets over time.  The performance of this fund gives weight to that argument.  I will leave this discussion to others, but there are several lessons to be learned here:

  • Every market environment is different.  During the market decline of 2000-2002 there were still a number of mutual funds and market sectors that held up pretty well.  During the sharp decline of 2008-09 pretty much no strategy worked well.  Funds such as Dodge & Cox Stock which had been stars in the 2000-2002 timeframe saw their strategy backfire and sustained out-sized losses for their shareholders.
  • A precipitous decline in assets often becomes a snowball.  In the case of Legg Mason Value Trust fund assets declined from just over $6 billion at the end of 2007 to about $1.35 billion at the end of 2008.  This is a greater drop than can be accounted for by the fund’s investment losses.  The level of redemptions served to amplify to fund’s losses.  This issue has continued through the present and has limited the fund’s ability to take advantage of the market rally since March of 2009.
  • It’s hard for superstar funds and managers to outperform forever.  Fidelity Magellan and American Funds Growth are two examples.  On the flip side the managers at Fidelity Contra and Fidelity Low-Priced Stock have continued to be top performers over long periods of time and in the face of significant asset growth in their funds.  They are the exception rather than the rule.

Evaluating an actively managed mutual fund is not an easy task, which is another argument for index products.  Many actively managed funds are not worth the extra expense ratios they charge.  This is not to say that there are not some excellent actively managed funds that are worth investing in.  Just be prepared to understand why these funds have been successful and to monitor them for changes in key personnel, major fluctuations (up and down) in the level of fund assets, changes in the fund’s investment process, and organizational changes that might impact the investment process among other factors.

Please feel free to contact me with your financial planning and investment questions.

Check out Morningstar.com to analyze your mutual funds and to get a free trial for their premium services.

Photo credit:  Wikipedia

 

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American Funds Growth – A Fallen Star?

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falling star

My last post asked Mutual Funds – Should You Pay Extra for Active Management?  As a follow-up I am taking a look at an actively managed Large Growth fund that was once a top-flight performer, but has really slipped in recent years.

Readers of this blog may note that two of the most popular posts have dealt with the American Funds in the context of their use in 401(k) plans.  American Funds Growth remains a major holding across the 401(k) universe.

The asset base of American Funds Growth (across all share classes) is huge at just over $116 billion, but it is down considerably from its 2007 high of about $202 billion.  Still the fund remains the largest in the Large Growth category.

Let’s compare Growth’s A Share class with the Investor Share Class (the most expensive) of the Vanguard Growth Index Fund.

The A shares have a low expense ratio of 0.68%, but the Vanguard fund’s expense ratio is 0.24%.  The average fund/ETF in this category had an expense ratio of 1.22% as of June 30.  Note the A shares carry a front-end sales charge; the returns below do not reflect this.

YTD

12 months

3 years

5 years

10 years

Amer. Funds Growth

17.86%

27.94%

10.03%

0.06%

8.72%

VG Growth Index

18.20%

31.08%

14.90%

3.39%

8.22%

As of September 30, 2012 – courtesy of Morningstar.

A Former Star Performer

The superior performance of American Funds Growth over the ten-year period is consistent with the fund’s annual performance.  From 2002-2006 the fund outperformed the Growth Index fund during each of these years.  Further the fund ranked no worse than the top 18% of all of the funds in the Large Growth Category.

A Fall From Grace

Since 2006, the story is a different one.  American Funds Growth  has lagged the Growth Index fund in each of these years.  Further the fund has ranked in the lower half of the Large Growth category in 3 of those 5 years.  For the three years ended September 30 the fund ranks in the 74th percentile (bottom 24%) of the Large Growth category.  The fund ranks in the 68th percentile for the trailing five years and the 24th percentile for the trailing ten years.

A Closet Index Fund?

While American Funds Growth’s expenses are generally reasonable (though not for some of the share classes that are sold via the broker channel) what are you getting by paying the extra cost?  Further, the fund’s R-Squared (a measure of correlation) with the Russell 1000 Growth Index over the past three years is over 97%.

Essentially the fund has become a closet indexer with lagging performance and higher expenses.  I’m not saying American Funds Growth will never be a consistent long-term performer again, nobody can predict the future.   I respect the American Funds as an organization.  But why invest in a closest index fund when you can invest in the real thing?  If your broker or registered rep tries to convince you otherwise ask them the same question.

Please feel free to contact me with your investing and financial planning questions.

For you do-it-yourselfers, check out Morningstar.com to analyze your investments and to get a free trial for their premium services.


Morningstar Stock Fund Investment Research

 

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Mutual Funds-Should You Pay Extra for Active Management?

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I was recently quoted in the industry publication Investment News in an article discussing how many Large CapCommon Sense on Mutual Funds: New Imperatives ... domestic equity mutual funds have become very highly correlated with their benchmark index.

The article’s author cited the American Funds Growth Fund of America as an example with its three year R-squared to the Russell 1000 Index having increased to 98% from 77% just five years ago.  R-squared measures the strength of the statistical relationship, in this case between the fund and its benchmark.

Here are my two quotes from the article:

“If I buy an active fund in the large-cap space, I want somebody who’s going to do something over the long term to outperform,” said Roger Wohlner, a financial planner at Asset Strategy Consultants. “Why pay 70 or 80 basis points for active management that doesn’t give you much differentiation from the index?” 

“Downside protection is one of the reasons that led Mr. Wohlner to rush some of his clients into the $5.5 billion Sequoia Fund (SEQUX) when it briefly opened to new investors in 2008. As the S&P 500 fell 37% in 2008, the Sequoia Fund fell 27%.” 

Both quotes reflect my belief that an active mutual fund manager needs to add value beyond what you can find in an index mutual fund or ETF.

Index Funds Often Outperform Their Actively Managed Peers

Especially with Large Cap funds, quite often index funds out perform a large percentage of their actively managed peers.  Let’s look at an example:

Vanguard Growth Index Signal (VIGSX) – Large Growth Category

YTD

1 year

3 years

5 years

10 years

Fund Return

10.77%

6.49%

17.66%

3.06%

5.97%

Category percentile

24

8

14

17

28

# Funds in category

1,543

1,499

1,328

1,137

736

As of June 30, 2012 via Fi360.com

By way of explanation:

  • Category percentile represents its ranking among all of the mutual funds and ETFs in this Morningstar Category.  For example for the three years ended June 30 the fund ranked in the top 14% of the 1,328 funds in the category with a three year track record.
  • The fund delivered these results quite cheaply.  The fund’s expense ratio is 0.10%.  This compares to the average mutual fund/ETF in this category of 1.22% as reported by Morningstar.
  • While this share class may not be available to all individual investors, the Admiral Share class ($10,000 minimum investment) and the ETF version (which can be traded commission-free at Vanguard) of this fund also carry a 0.10% expense ratio.  Even the basic Investor share class is very cheap to own with a $3,000 minimum investment and a 0.24% expense ratio.  In addition there are many other excellent index ETFs in this category that are solid low cost choices.

Why Pick an Actively Managed Fund? 

A bit over half of the money that I have invested on behalf of my clients is in some sort of index product, across both mutual funds and ETFs.

That said I still use a number of actively managed mutual funds as well.  What am I looking for in an active fund?

  • A long-term track record of excellence.  There are still a number of active fund managers who in my opinion add value.
  • A manager who excels at controlling their fund’s downside risk when the markets drop.
  • Superior management in an investment style that is not well-represented by index products.

As we have seen especially over the market cycle of the past decade, it is increasingly difficult for actively managed mutual funds to add value to investors over and above what inexpensive index funds deliver.   This is especially true with equity funds.  If your financial advisor suggests a portfolio of pricey actively managed mutual funds ask why (especially if these funds are proprietary products of their employer).  What added value do these funds provide over less expensive index alternatives?  If you advisor is paid all or in part via commissions I’ll bet his/her compensation is part of the answer.

Please feel free to contact me with your investing and financial planning questions.

For you do-it-yourselfers, check out Morningstar.com to analyze your investments and to get a free trial for their premium services.  Please check out our Resources page for links to some additional tools and services that might be beneficial to you.

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Should you Micromanage Your Mutual Fund Manager?

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I routinely receive a number of press requests via email during the course of the week.  I delete the vast majority of them because I either do not feel qualified to comment or I’m just not interested in being quoted.  However I did receive one today to which I did send a few thoughts to the reporter seeking input.

My Investments from the last year or so

He was seeking comments on:

“….financial planners who are surprised or have an opinion on some of the mutual funds that decided to buy Facebook stock in its first two weeks of trading. The monthly portfolio holdings for some fund families have been released in the last couple weeks.

Is it expected for some core mutual fund holdings (including those in 401ks) to participate in a volatile IPO like Facebook? Should Value or Dividend funds (have) picked up the stock, as a few did? Some funds have as much as a 5% to 7% allocation to the stock, is that worrisome?

Some of the funds that bought the stock between May 18 and May 31 include: …” 

My email response to this reporter was:

In the case of actively managed mutual funds such as the ones mentioned in the press request below, for better or worse you are buying into the judgment and skill of the manager or management team.  I would tend to evaluate the fund’s performance over time, their expenses, risk, adherence to a style, and other factors.  I wouldn’t necessarily look at their having bought Facebook during the IPO phase or any other singular holding.  Managers make some good bets and some that aren’t so good.  At this juncture it is a bit early to judge these purchases; however my focus would again be in the aggregate.  Have they made far more good bets vs. poor ones? 

The point of my response was that if one purchases an actively managed mutual fund (or separate account, annuity sub-account, closed-end fund, ETF, etc.) they are buying that manager’s skill and their ability to achieve some expected result.

There is a whole other debate about whether an investor should stick with lower cost index funds and ETFs vs. actively managed funds and that is not the point of this article.  For the record I am a fan of both, I use a high percentage of index products in my client portfolios but I also use a fair number of active funds as well.  As an advisor I have one advantage that many individual investors may not have in that I have access to institutional and other lower cost share classes for a number of the funds that I use both active and index.

In my opinion if you are looking at an actively managed fund you should evaluate the “whole picture.”  Typically when evaluating a fund, the starting points of my analysis include:

  • Track record relative to its peers.  It’s useless to compare a mid cap growth manager to one who invests in foreign large value stocks.  Note a stellar track record may not indicate success going forward so it is incumbent upon you to look further and understand what is behind that track record.  For example, how did this fund do on a relative basis in both up and down markets?
  • Expenses, how does the fund compare to its peers?
  • Alpha and Sharpe ratio.  These are measurements of the fund’s risk-adjusted return and to me are indicators of the value (or lack thereof) added by the manager.
  • Management tenure.  It is not uncommon for a successful fund manager to move on to greener pastures, especially if wooed by a competitor.  If the manager(s) who compiled the fund’s great track record are gone this is a big red flag, though not always a deal killer.  A number of years ago the long-time manager of a foreign fund that I like left.  Two of her underlings took over and frankly I think they have done an even better job.  Investing is about people, but it’s also about process.
  • Gain or loss of assets.  This is huge, especially if the fund invests in small or mid cap stocks.  Many funds have compiled a great track record with a low asset base.  One of the truisms of investing is that money chases performance.  Once a fund does well, new money can often poor in.  It can be tough for the manager to find enough good ideas in which to invest this new money.  Case in point is Fidelity Magellan.  This fund was managed by the legendary Peter Lynch and posted some fantastic numbers.  Money poured in, Lynch left, and the fund has been decidedly mediocre for a number of years.

These items are a starting point when researching an actively managed fund.  Overall my job is to develop portfolios for my individual and institutional (retirement plans, endowments, and foundations) clients that fit their needs.  Mutual funds and ETFs are the tools that I use.  I rely on the managers of these funds and ETFs and I judge them on their overall performance, not on any one individual holding or transaction.

If you need help evaluating your investments or with your financial planning  please feel free to contact me to discuss your situation.

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