Published Monday, Jaunuary 16, 2006Published Monday, Jaunuary 16, 2006
by Stephen Butler
A gypsy fortune teller peers into her crystal ball in the New Yorker cartoon while sitting across the table from a somber-looking Labrador retriever. She is saying, "I see a twenty-foot retractable leash in your future."
If only a glimpse into the future of mutual funds could be as predictable.
John Bogle sums it up perfectly in his great book, "Bogle on Mutual Funds," when he writes, "We can know who beat market averages and competitors in past years, but we have no way of knowing, prospectively, who will be a winner going forward."
In the heyday of mutual fund growth, some funds were able to create their own self-fulfilling prophesies.
For example, Fidelity Magellan Fund invested in more than 800 companies at one point; and when it showed an interest in any company, the stock of that company attracted the attention of other fund managers who piled on.
The Janus fund family, toward the end of the 1990s, had the remarkable privilege of receiving more than 30 percent of all new deposits coming into the entire mutual fund industry. They were great large-cap growth managers, and large growth happened to be the sector of the market that was hot during the period.
It doesn't take much to move a stock. Because all of a company's stock is valued based on the price of the infinitesimal portion that is sold on any given day, a single day's supply and demand can determine the stock price -- and therefore the value of the entire company. This is why there can be a disconnect between what the share price indicates a company's worth to be versus what the actual company may be worth to someone who wants to buy the whole thing.
The term for these disconnects between stock price and reality is referred to as "market inefficiency."
Good mutual fund mangers try to find these inefficiencies where the stock is worth less than the company's intrinsic value, because sooner or later, the stock price will efficiently value the underlying company.
In the world of mutual funds, we hope to find managers who have managed to find inefficiencies and overcome the odds against their success. There are a few out there who have managed to beat the market for many years in a row, such as the famous Bill Miller of Legg Mason fund who did it again this past year.
One approach advocated by some is to look at funds that have beaten the market over the past 10 years or more. Screening for fund rankings based on both 10- and 15-year time periods can be instructive.
Unfortunately, some of the greatest winners on a long-term basis are closed. Dodge and Cox Stock beats everyone hands down, but it has been closed to new investors for more than a year. Years ago, Sequoia fund and Vanguard Windsor both fell into the same category of long-term winners but were also closed over 10 years ago.
Vanguard's S&P 500 index fund shows annual gains of 11.61 percent over the past 15 years. That includes the period of the early 1990s when we had a 30-year market downdraft of "perfect storm" proportions. It ranks 81st on a list of all large cap funds ranked for 15-year performance -- this is out of a universe of some 1200 funds in the large cap category that have four and five-star performance ratings.
It would have been nice to be in any one of the funds that had performed better than Vanguard 500 index over the past 15 years, but what are the chances of picking a winner when the odds are about 11 out of 12 that we'll be stuck with a comparative loser?
According to a Jan. 8 article by Mark Hulbert of the New York Times, an elegant approach to assessing managers on a shorter-term basis is to compare their "value-added" results. Three finance professors from the universities of British Columbia and Michigan have determined that comparing the performance of past holdings against what the fund actually achieved can be a simple indicator of money management expertise.
In simple terms, this means "freezing" a fund portfolio at some point in the past and then determining what those stocks would be worth today given no changes in the portfolio -- essentially valuing what would have been a buy-and-hold approach vs. the actual performance resulting from all the subsequent trades.
The academics identified what they called the "return gap" described above and measured each fund's plus or minus number from 1985 through 2003. The return gap winners beat the market by an annual average of 3.8 percent; the losers trailed by 4.4 percent.
It would make sense that we would want to know that a money manger who trades typically half of his or her stocks in a year actually is generating improved results over what would have resulted had no trades been made at all. The return gap measures this talent in dollars and cents./p>
The most common alternative is a comparison of a fund's performance against the blizzard of benchmarks in a fund industry obsessed with proving that, in the words of National Public Radio, "all our children are above average."