Bob Barker is Your Financial Advisor
Chuck Jaffe at Marketwatch compares fund investing to games features on the 'Price is Right'. While the analogy is a touch strained, the concepts are sound:
1. The Bargain Game: Investors looking to buy a fund ultimately should boil their picks down to a select few, and then go bargain hunting. In this case, that means examining a side-by-side description of the funds to see how they intend to accomplish their investment objective. If two funds take the same strategy, the better bargain is clearly the fund with the lowest expense ratio; if they take different strategies in the same asset class, picking the better bargain will mean balancing any additional costs against an expectation of higher returns. If a fund can't convince you that it can deliver more for your money, it's no bargain compared to a lower-cost competitor.
2. Triple Play: The idea is to hit the big prize -- a fund you can count on, that can deliver to your expectations -- in several different asset classes. The first fund tends to be easy -- because it's a broad, safe choice with the fewest chances to go wrong -- but expanding your holdings into sectors, international stocks and more makes subsequent choices more difficult. To win, an investor must own several high-quality funds that move independently, so that a market nose-dive doesn't do permanent damage and scare the investor to dump the whole thing.
3. That's Too Much: In mutual funds, this is a contest investors should play when looking at a fund's expense ratio, and they can win if they remember one simple playing hint. For a stock fund, the ''too much'' number is 1.25 percent; for a bond fund, it's 0.75 percent.
Those numbers keep a fund slightly below average for their broad category; upon seeing costs above those levels, say ''That's Too Much!'' and consider whether it's worth the excess costs. Moreover, solid funds with numbers well below those averages are showing you a key reason for their success.
4. Take Two: In fund investing, the dollar target is the amount needed to be ''set for life,'' to achieve the ultimate goal of lifetime financial security. The key is picking mutual funds -- a few from the thousands of available choices -- that the investor believes can turn current and future savings into that jackpot.
To play successfully, investors should determine their target number, the amount needed to actually reach their goals; this makes the rest of the savings and investment process easier, as it makes it possible to determine the returns needed from funds in order to reach the goal. If your funds can't deliver those necessary returns, investment and/or savings habits most likely need to be changed or the game may be lost."
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.
Focus On: International Diversified
(Published 06/01/2007) What's the #1 indicator that a fund category isn't going to perform well? The number of new fund launches in it.
Fund companies launch new funds when they spot an opportunity to make money – not for fund investors, but for themselves, in the form of fees paid by new shareholders. Frequently, the most "saleable" funds are those that have performed well in recent years, enjoyed a significant buzz, and received steady, positive media coverage.
During the final stock bubble years in the late '90's, fund companies launched new tech or growth funds every few days. Back then, brand-new tech funds could bring in hundreds of millions (if not billions) right from the get-go. A classic example was Merrill Lynch Internet Strategies, which launched on March 22, 2000 (within days of the market peak). The launch arrived just in time to bring in over a billion dollars (with a sales load…) before diving nearly 80% in the first year alone.
Today, most new fund launches are ETFs (exchange-traded funds) that run the gamut from countries to currencies and tech to telecom. Many offer access to extremely specialized commodities, currencies, or investment strategies. Traditional open-end mutual funds, on the other hand, are arriving with much less variety. Since December 2006, the majority of new funds are international funds (although some are global). No less than two dozen new international funds have been launched in the wake of that category’s recent sizzling performance. Many investors focus on specific "hot" areas in international markets, like international small cap or real estate investments. There's even a renewed interest in single-country open-end funds.
Apparently, investors aren't anxious about making international investments after they experience great returns. Quite to the contrary, they look for even more focused and risky ways to make their money. We last saw this behavior during the good old tech bubble days, when general tech and growth fund launches in the 90's morphed first into focused Internet funds, then later into new and different types of Internet and telecom funds – remember "b2b" (business to business) "content," and "Internet infrastructure" funds?
Another indicator that we use is fund investor money flow, which analyzes which funds investors are buying and selling. Since fund companies launch funds in sectors where they perceive a demand, it should come as no surprise that investors have been piling into international funds at a record pace. Virtually all new fund dollars are going into foreign funds, even though the U.S. market has been plenty hot itself in recent years. We’re talking tens of billions a month – the sort of numbers that tech and growth funds saw in early 2000.
As contrarian investors, we firmly believe in doing exactly the opposite of what the investing herd does. The more popular a fund category is today, the more likely it is to under-perform tomorrow. That’s why we're downgrading international diversified funds yet again, from a 
(Weak) to our lowest rating, a 
(Least Attractive). Back in 2002, we rated international funds a 
(Most Attractive), and they held on until April 2004, when we cut the category down to a 
(Neutral). This category continued to perform well. A year later, in 2005, we downgraded international diversified funds to a (Weak), which is where their rating has remained prior to this edition. We're also now forecasting a negative return for this category - a first for us.
From best to worst in six years. Well, maybe we sold the emerging market and small cap foreign funds in our model portfolios just a bit too early. Maybe we’re still a little early - we’ll just have to wait and see. Maybe, just maybe, for the first time in fund history, the fund types that investors want the most will beat the market and the other fund categories over the next few years. But we doubt it.
Category Rating: (Least Attractive) - should underperform the market and 80% of the remaining stock fund categories over the next one to three years
Previous Rating: (last change 3/31/05): (Weak) - should underperform the market and 60% of the remaining stock fund categories
Expected 12-month return: -1% (decreased from 1% in our last Favorite Fund Report)
| RANK/FUND NAME/TICKER | ADDED | SINCE ADD | vs. S&P | 3 MONTH | 1 YR. |
| 1. UMB Scout WorldWide (UMBWX) | 9/01 | 117.95% | 71.40% | 4.22% | 16.81% |
| 2. Dodge & Cox Intl Stock (DODFX) | 8/02 | 184.08% | 119.81% | 6.21% | 24.41% |
| 3. Forward Intl Small Comp (PISRX) | 3/04 | 94.39% | 64.51% | 7.09% | 21.87% |
| 4. Harbor International Inv (HIINX) | 12/03 | 86.33% | 54.25% | 4.57% | 21.41% |
| 5. Fidelity Spartan Intl (FSIIX) | 8/02 | 127.80% | 63.53% | 4.64% | 21.48% |
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
Who's Your Mutual Fund Voting For?
Is your mutual fund supporting CEO pay raises, even when the CEO doesn't deserve it? TheStreet.com reports on a new study which shows that fund managers back compensation proposals by company management more than 75% of the time:
A study of the proxy voting records of 29 mutual fund families by the American Federation of State, County and Municipal Employees, the Corporate Library and the Shareowner Education Group indicates that between July 2005 and June 2006, fund managers backed management-sponsored proposals on executive compensation just over three-quarters, or 75.8%, of the time.
That represents a slight uptick from 75.6% during the year-earlier period.
'These mutual funds are failing to protect the assets of their clients,' says Gerald W. McEntee, president of AFSCME. 'CEOs should be paid for performance. Investors in these mutual funds should be outraged that their assets are being used to prop up undeserved CEO pay.'"
That pay is undeserved, the study says, because higher pay for company management doesn't generally lead to more profitable companies:
...authors of the report cite research showing that among S&P 500 companies, the largest increases in total compensation actually correlated poorly with improvements in long-term corporate performance."
LINK