TCS Daily

Mutual Failure

By James K. Glassman - December 3, 2002 12:00 AM

Despite the miserable performance of the stock market in recent years, the number of Americans owning mutual funds continues to rise. At last report, 48 million families owned stock funds. That's roughly half of all U.S. households - up from only about one-fourth in 1992 and one-twentieth in 1980.

Mutual funds have democratized finance like no other invention, giving small investors the benefits of diversification and professional management that, in the past, only the rich could afford. A mutual fund is a portfolio - on average, about 100 different stocks (or bonds or a mix), managed by an expert who buys and sells them according to guidelines set out in the fund's prospectus.

But mutual funds also have drawbacks. First, they can be expensive. Second, most of them are run without regard to the tax consequences to investors. Third, managers - most of whom have broad discretion - sometimes move their funds into realms investors never anticipated (small-caps, tech stocks, cash). And, fourth, many funds don't perform particularly well. These deficiencies are no secret, but, after weighing them against the benefits, I have always concluded that funds make good sense for investors who have neither the time nor the inclination to assemble their own portfolios

A new study by the research firm Lipper Inc., however, raises profound doubts.

The study focused on the deleterious tax effects of owning mutual funds. Since most fund managers trade a lot, their stock sales can generate big - and surprising - tax bills for shareholders, even in years when the value of the fund declines. Left to their own devices, these same investors might simply buy and hold individual stocks, rarely incurring a gain.

I was troubled even more by Lipper's top-line numbers - the performance of stock funds even before the tax bite. Most mutual funds do no better than monkeys throwing darts at the stock pages (in the immortal metaphor of Princeton economist Burton G. Malkiel). But what is truly remarkable is that hundreds of funds do worse than the rules of chance would seem to allow.

In its new study, Lipper found that for the five years that ended Dec. 31, 2001, the average U.S. diversified stock fund returned an annual average of 9 percent (after annual operating expenses but before any "loads," or sales charges), compared with a return of 10.7 percent for the benchmark Standard & Poor's 500-stock index.

After accounting for taxes, the typical investor in such a fund achieved annual returns of just 6.4 percent.

Meanwhile, funds with front-end loads produced an average annual return between 1996 and 2001 of just 7.6 percent (or three points less than the S&P!) and a mere 5.5 percent after taxes.

But forget taxes. Just look at returns - price appreciation plus dividends minus expenses. For the 10 years that ended last December, the average fund returned 11.4 percent while the S&P returned 12.9 percent. What's shocking is that even before expenses, the average fund did worse than the index over the past five years and 10 years.

Still, maybe just a few funds did especially poorly and pulled down the averages. To find out, I asked a Lipper researcher to take a closer look at the numbers. Here are the results:

In 11 of the past 15 years, the S&P index outperformed a majority of U.S. diversified equity funds.

In five of the 15 years, less than one-fourth of the funds beat the S&P.

Over the past 10 years, only 194 funds - out of a total of 654 - beat the S&P. The proportion of index-beaters - just 29.7 percent - is actually exaggerated because of what's called "survivor bias": that is, funds that performed so poorly that they folded or were merged out of existence during the 10 years aren't included in the base of 654.

Figures like these make investors wonder why they should put any money at all into "managed" mutual funds - that is, funds that are run by real human beings, who charge an average of about 1.4 percentage points in expenses (again, not counting sales costs). Instead, why not simply invest in a fund like Vanguard Index 500 (VFINX), a mutual fund that owns all the stocks in the S&P 500 index itself and, since it requires no highly paid manager, charges annual expenses of just 18 basis points (that is, less than one-fifth of a percentage point)? According to Morningstar, the Chicago research firm, Vanguard Index 500 has beaten 76 percent of its managed-fund peers over the past 10 years, and a low expense ratio explains its success.

If the difference between 1.4 percent and 0.18 percent doesn't sound like much, take a look at the fund cost calculator that the Securities and Exchange Commission put up on its Web site a few years ago. The calculator is a breeze to use, but you have to make some assumptions.

I started with a hypothetical $10,000 and figured it would be invested for 30 years, achieving gross returns (before expenses) of 11 percent (roughly the market average for the past three-quarters of a century).

Plugging in those numbers, I discovered that, for the fund charging 1.4 percent, the $10,000 would grow to $149,967. That sounds awfully good - except that the SEC calculator found that total costs over the period were $78,956, which is more than eight times your original investment and 34 percent of the gross returns of the fund. Imagine this advertising slogan: "Invest With Us Long-Term. We'll Take One-Third of Your Account as Our Fee."

For comparison, I assumed the same return for an index fund charging expenses of 0.18 percent. In this case, the $10,000 grows to $216,878, with expenses of only $12,045. Such a fund puts an extra $67,000 in your pocket (45 percent more) over 30 years. Also, because index funds usually have low turnover (an average of just 4 percent of the holdings are bought and sold annually), they generate lower tax bills.

So why invest in managed funds at all? Good question. John Bogle, founder of Vanguard, once said that investing in such funds was like getting married a second time: "It's the triumph of hope over experience." But, while I'm skeptical of the ability of most fund managers to beat the indexes - especially in light of the latest Lipper numbers - I haven't given up yet.

Consider Legg Mason Value Trust (LMVTX). Manager Bill Miller has beaten the S&P in each of the past 11 years (though he's a couple points behind with a month to go in 2002). For the past decade, Miller's annual average return has been 15.2 percent - more than 5 points better than the index, even after expenses average 1.7 percent.

There are two problems, however. First, past performance is no guarantee of future success. And, second, extensive research has shown that, with mutual funds, you don't necessarily get what you pay for. In fact, academic research has found a link between high expenses and low returns.

What about loads? Again, the correlation isn't promising. The Lipper study discovered that the average fund with a front-end charge had annual returns that were nearly 1 percentage point lower per year - before the load - than the average no-load fund.

Again, this is not a reason to dogmatically reject funds with sales charges. If you hold such funds long enough (10 years or more), the load's effect dissipates, and many load funds charge significantly lower annual expenses than no-load funds. Fiddling with the SEC calculator, I found that, at an 11 percent annual return, a fund that charges a 5 percent load and 1 percent annual expenses produces about the same return, after all costs over 10 years, as a no-load fund charging 1.4 percent in annual expenses. (Load funds also help investors stick to a buy-and-hold discipline. If you have paid a sales charge, you are less likely to bail out after a few months.)

And there are some superbly managed funds that charge entrance fees. Two that I have mentioned in the past are American Funds Washington Mutual Investors (AWSHX), which has beaten the S&P by an average of more than 10 percentage points over the past three years and is less volatile than the market as a whole, and FPA Capital (FPPTX), which has whipped the index by more than 6 percentage points annually since 1992 and ranks in the top 1 percent of all funds. Washington Mutual's "A" shares charge a 5.75 front load, but annual expenses are only 65 basis points. FPA, which focuses on smaller companies, has a 5.25 percent load and expenses of 84 basis points.

Still, the best strategy is to seek good, consistent no-load funds with low expense ratios (you can find expenses, by the way, on the Morningstar Web site). Here are three of my longtime favorites: the Torray Fund (TORYX), which charges 1.1 percent and has returned an annual average of 13.2 percent over the past 10 years; Jensen (JENSX), with 1 percent expenses and a three-year average return that has beaten the S&P by an incredible 16 percentage points; and Dodge & Cox Stock (DODGX), with 0.54 percent expenses and 14.3 percent average annual returns over 10 years. Each is managed in a tax-friendly buy-and-hold style.

In the end, while the Lipper study shakes my confidence, I still think that great managers such as Bob Rodriguez of FPA, Bill Miller of Legg Mason and Bob Torray of Torray can beat index funds. But a good approach is to own both managed funds and index funds. You can buy the S&P 500 either by purchasing shares directly in a fund like Vanguard's or by purchasing shares of Standard & Poor's Depositary Receipts (symbol: SPY on the American Exchange), which are commonly called "Spiders" and trade at one-tenth the value of the S&P index itself. There's even a mutual fund that combines both approaches: TIAA-CREF Growth & Income (TIGIX), run by the world's largest pension firm and charging only 43 basis points in expenses.

The choices are abundant, but the mystery remains: Why do mutual fund managers do so poorly at their chosen profession? No one has ever given a satisfying answer to that question. My own guess is that the stock market truly is efficient, so, except for a few geniuses, no one can get the better of it over time. Those who try the most frenetically - jumping in and out of stocks in a futile attempt to get an edge - make the most mistakes and incur the highest transaction costs. Stay away from them.



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