The Fund Industry's Talent Problem
The past three years' storm gave large-cap fund managers a great chance to outshine index funds. But most blew it anyway.
For years we've heard that most big-cap fund managers have a tough time beating cheap, large-cap S&P 500 index funds, which simply replicate that index. Over the past couple of years, however, active managers could've used bets on smaller stocks or even cash to top the index. Unfortunately, less than half did so in 2001 or over the past three years. And less than seven in 10 big-cap funds beat the index over the past five, 10 and 15 years, according to Chicago research house Morningstar.
So now, even some fund managers are asking tough questions. "What are you getting from your actively managed stock fund?" asked
Invesco emigre and nascent hedge fund manager Jerry Paul, in a portion of last week's
The S&P 500 is still a brutal taskmaster
|Source: Morningstar. Returns through Feb. 28.|
One reason for underwhelming results is the gush of new funds. A booming economy, a bull market and the rising popularity of 401(k) plans sparked explosive growth in the fund business. Today, there are more than 4,700 stock funds out there, up from about 1,200 some 10 years earlier. Just as a the glut of new baseball teams winnowed pitching talent, the gush of new funds has probably spread the corps of skilled stock pickers pretty thin. Index funds' low expenses give them a head start, too. Every fund's returns are calculated after their annual expenses are accounted for. Consider that the Vanguard 500 Index fund carries just a 0.18% annual expense ratio, compared with 1.44% for the average U.S. stock fund. For a sense of how much low expenses boost your investment, compare the Vanguard 500 fund with the relatively cheap (FMAGX) Fidelity Magellan fund, which carries a 0.88% expense ratio. On a $10,000 account with identical performance, the Vanguard fund would cost you $230 over 10 years, compared with $1,202 shaved off your investment in the Fidelity fund. For the record, the Magellan fund only narrowly trails the index after fees over the past 10 years.
|What Are the Odds?
The percentage of big-cap funds that top the S&P 500 over these periods
|One Year||Five Years||10 Years||15 Years|
|Source: Morningstar. Data through Dec. 31, 2001.|
Beyond expenses, active managers face another hurdle: an often-necessary obsession with short-term results. Because many managers' performance vs. benchmarks and their peers' is tracked and discussed quarterly, there's a natural incentive for many to juggle their portfolios to focus on "must-own" stocks and sectors that are working at a given time. That type of short-term trading and thinking can lead to lousy long-term results. High trading or turnover often confuses motion with getting somewhere because pros and amateurs alike are usually unable to predict the market's gyrations in the short term. It can also trigger capital gains distributions, which whittle your real returns -- how much money you have after you pay your taxes. The large-cap blend Vanguard 500 Index fund has been more tax-efficient than 93% of its peers over the past decade, according to Morningstar. Of course, this isn't to say that actively managed funds are pointless. Small- and mid-cap funds often trounce their indices. And there are many actively managed big-cap funds that do beat the index consistently. Many are offered by quiet giant American Funds, and Ritchie Freeman's (SHRAX) Smith Barney Aggressive Growth fund has dusted the index and its peers routinely. Bill Miller, manager of the (LMVTX) Legg Mason Value Trust fund, has trounced the S&P 500 in each of the past 11 years. Then again, there are thousands of fund managers out there, and he's the only one to do so. Not only are the odds against you digging up a gem of a fund, the consequences can be painful if you saddle yourself with a loser. Over the past five years, the sputtering (FLRFX) Invesco Growth fund, for instance, averages a 5.7% annual loss. That trails the S&P 500 by more than 14 percentage points. On a $10,000 investment in that fund you'd be in the red, compared with a more than $6,200 gain in an S&P 500 index fund. The bottom line is that you don't have to be an expert to see that simply picking an index fund will help you beat most of the "experts."
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