Reading The Big Fund Tea Leaves

July 1, 2005

We’re always trying to figure out what categories of funds are best positioned to perform well going forward. These attractive fund categories often are in areas fund investors don’t like. This contrary strategy works well in investing because where lots of money goes, opportunity is hard to come by. 

In this hunt for the unloved, we look at numerous factors. One way to help determine what broad style of investing to consider going forward is to look at what the biggest funds are doing.

Tracking top funds by asset size is a nice measure of past performance and overall appeal to fund investors wrapped up in one. The top ten by assets represents about 10% of total assets in all mutual funds. These are the funds that are most popular with investors, and, by our theory, should underperform other funds going forward.

Here are the ten current biggest stock funds by assets:

Vanguard 500 Index

American Funds Investment Company Of America

American Funds Washington Mutual

American Funds Growth Fund of America

Fidelity Magellan

Fidelity Contrafund

Dodge & Cox Stock

American Funds EuroPacific

Fidelity Low Priced Stock

Vanguard Total Stock

What are these funds? Only two are blatantly growth oriented: American Funds Growth Fund of America and Fidelity Contrafund. Of the two, only the American fund is aggressive, with a 40%+ year during the roaring bull market of the nineties. Contrafund is about as conservative as a growth fund gets. Only the American Funds Growth Fund of America is riskier than investing in the S&P500.

Top funds by assets are almost always large cap-oriented funds whether large cap investing is in favor or not. You just can’t invest tens of billions into small cap stocks that easily. That said, Fidelity Low Priced stock funds appearing at the top list is a sign that small cap investing is very popular with fund investors today.

Vanguard Total Stock is now on the list, as investors realized that one thing their portfolio clearly missed in 2000 was smaller cap stocks. This is another sign that small cap stocks are about to stop adding value to a larger cap stock index like the S&P500.

Here is what the same list looked like in September 2000 – even a few months after the great tech crash started, along with the trailing, five-year  total return as of last month (5/31/05):

<b>Vanguard 500 Index  -9.87%

Fidelity Magellan -16.41%

American Funds Investment Company of America +13.34%

Janus -37.14%

American Funds Washington Mutual +26.28%

Fidelity Contrafund +15.94%

Fidelity Growth & Income -3.62%

American Century Ultra -23.19%

American Funds Growth Fund of America +.15%

Janus Twenty -36.72%</b>

If you had built this “top 10” list as your portfolio five years ago, you’d still be down almost 11% today. The average mutual fund is up over the last five years, but not by much.

More interesting, if you had thrown a dart at a list of the thousands of no load funds back in 2000 and bought just one fund you would have had about an 80% chance of beating this portfolio of the 10 biggest funds.

While some of the funds that have performed acceptably well over the last few years are still on the top ten list, the ones that are off the list are the ones that fell the most (no surprise there). Of this old top ten list, at least three were growth funds – more so than on today’s top ten list. Only two were clearly value funds, the rest a blend of value and growth. Today, three funds on the list are value-focused. There were also no foreign funds and no small cap-oriented on the 2000 top ten, two of the best performers over the last five years. People missed those boats chasing U.S. growth stocks.

This pattern of the most popular funds and fund categories underperforming is not a new one. If you look at the top 10 by assets list from 1990, you’ll find many value-oriented funds – as value funds ruled the roost in the 1980s:

<b>Fidelity Magellan

Vanguard Windsor

American Funds Investment Company of America

American Funds Washington Mutual

Fidelity Equity Income

Pioneer II (now Pioneer Value)

American Funds American Mutual

Lord Abbett Affiliated

American Century Select

MSDW Div Growth (now Morgan Stanley Dividend Growth)</b>

In the 1990s you’d have been better off with growth-oriented funds. In fact, had you bought this list from 1990, you would have underperformed the dartboard mutual fund once again going forward.

Ironically, these funds would have made for a decent buy list in 2000. If you bought them all in 2000 – ten years after they were popular and had top ratings – you would have made about 13.5% over the next five years (2000 – 2005) instead of losing 11% in the 2000 top ten list.

You’ll also notice S&P500 index investing hadn’t caught on by 1990. Too bad. Over the next decade (1990 to 2000) an index fund would have beaten the vast majority of other funds. But by the time indexing rose to the top and experts began acknowledging its supposed inherent superiority, indexing started to underperform most actively managed mutual funds. The Vanguard 500 Index fund’s success in asset gathering in 2000 (it had over $100 billion in assets) was one reason we wrote a negative article about S&P500 investing compared to non-index funds in 2000.

This 1990 top 10 list is even more value-skewed than the current list – the majority of these funds are value-oriented. It’s no wonder the decade of tech started when people were lapping up funds with “dividend growth” in the name, a decade where dividend-less stocks beat everybody else by a country mile.

So what does today’s list tell us?

First off, the list doesn’t offer much insight to sector funds as these funds will never make a top assets list because they lack the broad appeal (look to relative size compared to other sectors and new fund launches for insight). At its best, the top 10 list is a measure of the current popularity of growth to value.

Today’s list does confirm our current belief that growth stocks will beat value stocks (and therefore, growth-oriented funds will beat value funds) over the next five years or so.

Unlike 1990 or 2000, the list is not so skewed towards one area as to point to the obvious future winner (growth in 1990, value in 2000). This likely means growth will beat out value by a fairly slim margin (historically speaking) going forward.

The current top 10 list also indicates that small cap and foreign-oriented funds should not perform particularly well going forward. These were areas we have favored in the newsletter in the past precisely because of the lack of salability.

Here’s the prediction that could ruffle a few feathers: Dodge & Cox Stock is going to underperform over the next decade. Its appearance on the top ten list means its underperformance is practically guaranteed.

Another interesting item the list tells us is that there is still way too much money in large cap growth, despite the fact that these old growth stars have underperformed for the last five years.

It’s entirely possible that by 2010 this top ten list will be virtually all value funds (and maybe more foreign funds). Because we don’t know how far the pendulum will swing away from large cap growth and tech, we’re not betting the farm on these areas. Maybe by 2010 value and old economy stocks like ExxonMobil will trade at higher P/E ratios than Intel and Microsoft and all the funds on the top list will be value, small cap, or foreign.

The bottom line is this: if fund investors prefer value funds you should favor growth funds; if they like growth funds buy value funds. The more they favor one the more you can favor the other. Don’t look for the press and fund experts for help – they love Dodge & Cox today, they loved Janus in 2000. They loved Magellan and Pioneer Value in 1990.

This is especially crucial today as we’re getting some emails from subscribers (and managed account clients) that are wary about some of our fund picks and are asking for alternates. What we suspect they don’t like is the poor, five-year trailing returns. 

Just remember three things: 1) we didn’t pick these funds five years ago, before they posted these unimpressive numbers, we picked them recently, after they underperformed, 2) many of our best picks looked bad when we picked them, then went on to post stellar returns, 3) what looks good today often doesn’t do so hot going forward (as the above data shows).