When Bad Things Happen to Good Fund Shareholders

August 17, 2012

Fund investors are slowly losing interest in stock investing. Since the peak of the market in 2007, just over $100 billion has left stock funds.

Some of this may just be demographics. Baby Boomers are following the age-old advice to shift from stocks to bonds as they grow older, despite the fact that this general recommendation might not apply in a world in which bonds yield less than stocks. But two 50%+ haircuts in the stock market since 2000 (with a "flash crash" thrown in for good measure) certainly aren't inspiring confidence in the stock market. Fear of another global catastrophe is keeping some money in seemingly low-risk places, but that doesn’t explain the shift within stock funds.

Half a trillion has left active management in favor of index funds. Vanguard, with its newer ETFs and successful index funds, has brought in much of the money leaving actively managed funds.

Investors may like the indexes' low fees, but the more likely reason for the exodus is poor performance by actively managed funds, including some popular funds run by superstar managers – call ‘em Starvisors.

Fund investor assets are heavily skewed to a relatively small group of popular funds. These funds generally become popular after they've performed well and their good performance has generated  high ratings and favorable reviews. Fund investors love long-term winners with great 5, 10, and even 15-year, gimmick-free track records. These funds also populate many 401(k) choices, since professional fund pickers gravitate toward these superstars as well.

But most funds can outperform for only so long. Suddenly, former chart toppers aren't beating their benchmark index funds. Even worse, they're faring worse than other actively managed funds run by ordinary managers, often with higher fees and no great track record to speak of. Sometimes, the underperformance is severe enough to wipe out years of outperformance. Other times, it isn’t just a year or two, but five bad years in a row.

In many cases, the funds lose more investor money than they've made because much of the money came in near the top. The  "shareholder-wealth-created" by the fund turns negative well before the funds' official returns look that bad.

Eventually, the funds are quietly removed  from 401(k) lists of "great" funds and replaced with new stars. After years of saying "stick with it," former media fans move on.

At MAXfunds.com, we’ve been following this hot-then-not trend since 1999. Back then, it was a big pile of tech and growth stars that were bringing in all the money. Since our rating system has always  punished funds for bringing in money fast, many hot funds had poor ratings even before they began to underperform. 

At some point following the growth stock bubble burst, the world began to notice other funds that did well, relatively speaking. Often, they were funds with a "value" bent. The money began piling in. Out of growth, into value. No more triple digit P/E ratios. The "smart" money was moving into value stocks, stocks with a healthy dividend or low valuations, and solid (if unexciting) growth prospects. The screens began focusing on risk. Investors essentially declared, "No more triple digit years followed by 70% losses. I want solid performers." And the cycle began all over again.

Money can corrupt a fund in mysterious ways. First, it can actually boost returns as the manager buys more of the same, pushing up the prices of the underlying securities, and therefore, the fund price. The money can also lead to overconfidence. I must be good because I manage $50 billion dollars. Another problem is the type of investments you can buy with $50 billion at your command differs from what you can buy with $500 million. You start needing big ideas, big themes, and big stocks.

With overstuffed tech funds, that became the same 100-or-so big cap growth darlings of the late 1990s. In the mid 2000’s "value rebound bubble," it was mega banks. Banks never had 100 P/E ratios and zero dividends. The banks were good values. So were stocks abroad. But  that bubble was just as dangerous as Cisco was in 2000. The problem with the banks was right there on the balance sheet - loans backed by inflated real estate. Imagine a bank that only made loans to tech startups in the late 1990s. If that hypothetical tech bank had a 10 P/E ratio and a 4% dividend, it wasn’t a good value, if the currently performing loans were made to companies about to have a hard time paying back loans. 

But who was saying a solid value stock like Lehman would tank because of mortgages (of all things) back in 2006? 

Value got hot. Dividends got hot. Old Economy in, New Economy out. Once bitten, twice shy. As it turned out, many zero-dividend growth stocks did better. Banks failed. Apple and Google soared. 

In no particular order, and with slightly different reasons for the bad returns, here is a list of former top funds, most still popular and with billions of dollars in assets, that are now solidly in the bottom of the last five years, with a collective average annual underperformance of the S&P 500 of 5.23%.

Stars that lost their shine, and their 5-year returns

Data as of 7/30/2012
Vanguard 500 Index 5 YEAR RET.
Vanguard 500 Index (benchmark) (VFINX) 1.04%
Fairholme (FAIRX) 0.76%
Legg Mason Cap Mgmt Value A (LGVAX) -7.76%
American Funds Growth Fund of Amer A (AGTHX) 0.00%
Dodge & Cox Stock (DODGX) -1.20%
Third Ave Value (TVFVX) -4.44%
Davis NY Venture (NYVTX) -1.58%
Longleaf Partners (LLPFX) -2.57%
Calamos Growth A (CVGRX) -0.30%
CGM Focus (CGMFX) -7.52%
Legg Mason Cap Mgmt Opportunity A (LGOAX) -12.47%
Brandywine (BRWIX) -6.77%
JHancock Classic Value (PZFVX) -6.41%


Not all funds that get big collapse, but lately, the odds of a star fund even matching an index going forward appear to be declining. Some continue to pull off solid returns; several Fidelity funds come to mind (Fidelity Growth Company, Low-Priced Stock, Contra), Pimco Total Return (except for a brief slip last year), Yacktman, Sequoia (closed), and Oakmark. 

Ironically, as a group, many of the fallen heroes from the late 1990s beat the funds in the superstar table above. The market has a way of kicking you when you are down. 

The core reason for this migration to indexing from actively-managed stock-fund picking  is that picking fund winners may be getting harder – and it was never easy. After being burned twice, investors are moving on for good. The money is not going back to tech and Internet funds; it's going to index funds.

The typical stock investor return must be lower than the S&P 500’s own poor showing – many were in growth funds that fell harder than the index, and then moved to value funds that fell harder in the next slide.

This could create opportunities in non-market-cap-weighted, low fee, lower-asset, actively-managed funds, since we generally observe that where money goes, poor returns ultimately follow.