Many financial writers wish for one thing at Christmas. They want their readers to suffer from classic, daytime soap opera amnesia. Steve Forbes should know. The publishing executive for Forbes magazine said, “You make more money selling advice than following it. It’s one of the things we count on in the magazine business—along with the short memory of our readers.”31
Take the article written by Business Insider’s Nick Levis on July 20, 2011.32 He boldly pumped “7 Top Mutual Funds with Long Term Solid Track Records.” None were stock market indexes. That would be boring. Instead, he promoted cotton candy over broccoli.
He chose seven actively managed mutual funds with strong historical track records. I asked Russel Kinnel, Morningstar’s director of mutual fund research, what to look for when picking mutual funds that we hoped would do well in the future. He said, “Low fees are the best predictor. . . so go with a low-fee fund every time.”33 The funds with the lowest fees, of course, are indexes. That’s why Warren Buffett instructed his estate’s trustees to put his heirs’ proceeds into index funds when he dies.
Those following Nick Levis’s advice, however, are likely crying over their wallets. Since the article was published, the S&P 500 has scorched all seven of his recommendations. According to Morningstar, investors splitting $10,000 evenly into each of the former hot tickets would have seen their money grow to $12,219 by November 13, 2015. By comparison, a $10,000 investment in Vanguard’s S&P 500 index fund would have been worth 36 percent more. It would have grown to $16,625.34
Academics call this “reversion to the mean.” Winning funds rarely continue to win. And when they disappoint, investors pay the price. By the end of 2015, the S&P 500 had a better 5-year track record than each of Mr. Levis’s former hot funds. The index also reported a better 10-year track record.
I don’t mean to pick on Mr. Levis. Finance writers need to push a bit of excitement. That’s their bread and butter. A Fortune magazine writer once said, “By day, we write about, ‘Six Funds to Buy NOW!’. . . By night, we invest in sensible index funds. Unfortunately, pro-index fund stories don’t sell magazines.”35
When Best Mutual Fund Lists Can Strip You Naked
Here’s an example from May 2010. US News and World Report published, “The 100 Best Mutual Funds for the Long Term.” Each year, most finance magazines publish something similar. They should carry x-rated warnings.
The writer’s opening line stated, “When it comes to choosing a mutual fund, there’s nothing better than a solid track record.” This would shock most mutual fund academics.
It’s like saying, “When it comes to running on glass, nothing beats bare feet.” “The 100 Best Mutual Funds for the Long Term” listed 50 US stock market mutual funds (the remaining 50 were bond funds, balanced funds, and international funds). US News broke them into five different categories: Value, Growth, Small-Cap, Mid-Cap, and Large-Cap.
What Exactly Are These Categories Of Funds?
You don’t need to know what Value Funds, Growth Funds, Small-Cap, Mid-Cap, and Large-Cap Funds are, but here’s a primer. A Value Fund is made up of cheap stocks. A Growth Fund is made up of stocks with high expected business earnings. Small-Cap, Mid-Cap, and Large-Cap funds are those defined by the stocks within them. For example, a Large-Cap Fund is made up of large stocks (like Coca-Cola, Walmart, and Apple). A Small-Cap fund is made up of smaller company stocks. Medium-Cap funds represent medium-sized stocks.
Investors could theoretically buy an actively managed Small-Cap Fund or a Small-Cap Index Fund. But I don’t think you should bother. Instead, the portfolios of funds that I recommend (and those that I own myself) keep things simple. They’re made up of broad-based index funds that own a little bit of everything.
The author wrote:
We chose funds with positive 10-year trailing returns and, for stock funds, names that beat the S&P 500 over that time frame. . . . Our score is based on the ratings of some of the mutual fund industry’s best-known analysts . . .36
He should have written:
We have ignored financial academic studies. Instead, we chose yesterday’s winning funds and fortunetellers’ picks. Those purchasing these funds will likely underperform their respective benchmark indexes by an average of 2.31 percent per year. Over a 30-year period, a retirement nest egg’s potential could be reduced by a third.
Where am I getting this 2.31 percent? I tore at the forecaster’s toga. I used portfoliovisualizer.com to see how these recommended funds performed since the article’s May 2010 publication.
Some of the funds changed names (as a result of poor performance, company mergers, or acquisitions). But with the exception of the Madison Mosaic Disciplined Equity Fund, I tracked down every one. Keep in mind, these were index-beating funds when US News had listed them.
But after the article was published, index funds crushed them in all five categories. The recommended value funds, listed on Figure 3.2, averaged a compound annual return of 8.77 percent between May 2010 and May 2016. Vanguard’s Value Index (VIVAX) averaged a compound annual return of 11.13 percent during the same time period.
Ticker Name
YACKX AMG Yacktman Fund
ACGIX Invesco Growth & Income Fund Class A
EQTIX Shelton Core Value Fund Class S
AMANX Amana Mutual Funds Trust - Income Fund
VAFGX Valley Forge Fund, Inc.
FVALX Forester Value Fund
FDSAX Focused Dividend Strategy Portfolio Class A
AGOCX Prudential Jennison Equity Income Fund Class C
AUXFX Auxier Focus Fd Investor Shares
HOVLX Homestead Funds, Inc. - Value Fund
Figure 3.2 US News and World Report: Recommended US Value Funds
Source: US News and World Report; portfoliovisualizer.com
The writer’s US Growth fund recommendations, listed in Figure 3.3, averaged a compound annual return of 10.73 percent per year. Vanguard’s Growth Index (VIGRX) stomped them. It averaged a compound annual return of 12.35 percent.
Ticker Name
JENSX Jensen Quality Growth Fund Cl J
FKGRX Franklin Growth Fund Class A
LHGFX American Beacon Holland Large Cap Growth Fd Inv Cl
VHCOX Vanguard Capital Opportunity Fund
PTWAX Prudential Jennison 20/20 Focus Fund Class A
FCNTX Fidelity Contra Fund
PROVX Provident Trust Strategy Fund
MINVX Madison Investors Fund Cl Y
BUFEX Buffalo Large Cap Fund, Inc.
AMCPX AMCAP Fund, Class A Shares A
Figure 3.3 US News and World Report: Recommended US Growth Funds
Source: US News and World Report; portfoliovisualizer.com
The recommended US Small Cap stock market funds, listed in Figure 3.4, really got thumped. They averaged a compound annual return of 8.39 percent per year. Vanguard’s Small Cap Index (NAESX) averaged a compound annual return of 10.79 percent per year.
Ticker Name
RYOTX Royce Micro-Cap Fund Investment Class
FSLCX Fidelity Commonwealth Trust Fidelity Small Cap Stock Fund
OTCFX T. Rowe Price Small-Cap Stock Fund
RGFAX Royce Heritage Fund Service Class
FOSCX Tributary Small Company Fd Instl
LZSCX Lazard US Small-Mid Cap Equity Portfolio Institutional Shares
LRSCX Lord Abbett Research Fund, Inc. - Small-Cap Series - A Shares
PENNX Royce Pennsylvania Mutual Fd, Investment Class
BVAOX Broadview Opportunity Fund
NBGNX Neuberger Berman Genesis Fd
Figure 3.4 US News and World Report: Recommended US Small-Cap Funds
Source: US News and World Report; portfoliovisualizer.com
The recommended Mid-Cap stock funds also dragged the market. Listed in Figure 3.5, they averaged a compound annual return of 9.71 percent. Vanguard’s US Mid-Cap Index (VIMSX) averaged a compound annual return of 11.69 percent.
Ticker Name
WPFRX Westport Fd Cl R
FLPSX
Fidelity Low-Priced Stock Fund
CHTTX Anton/Fairpointe Mid Cap Fund Class N
FMIMX FMI Common Stock Fund
WPSRX The Westport Select Cap Fund Class R
CAAPX Ariel Appreciation Fund Investor Cl
GTAGX Invesco Mid Cap Core Equity Fund Class A
DMCVX Dreyfus Opportunistic Midcap Value Fund Class A
SPMIX S&P MidCap Index Fund Class S
PESPX Dreyfus Midcap Index Fund
Figure 3.5 US News and World Report: Recommended US Mid-Cap Funds
Source: US News and World Report; portfoliovisualizer.com
They also recommended the 10 US Large-Cap funds in Figure 3.6. One is missing in action, so I averaged the returns of the nine that remain. As a group, they performed poorly. They averaged a compound annual return of 8.77 percent between May 2010 and May 2016. Vanguard’s Large-Cap Index (VLISX) averaged a compound annual return of 11.73 percent. Vanguard’s S&P 500 Index (VFINX) averaged 11.86 percent.
Ticker Name
FAIRX Fairholme Fd
PRBLX Parnassus Core Equity Fund-Investor Shares
OAKMX Oakmark Fund Cl I
PBFDX Payson Total Return
ACEHX Invesco Exchange Fund Shs
MPGFX Mairs & Power Growth Fund
EXTAX Manning & Napier Fd, Inc. Tax Managed Srs Cl A
CLVFX Croft Value Fd Cl R
HEQFX Henssler Equity Fund
YACKX AMG Yacktman Fund
Figure 3.6 US News and World Report: Recommended US Large-Cap Funds
Source: US News and World Report; portfoliovisualizer.com
As seen in Figure 3.7, the five categories of recommended US stock market funds underperformed their benchmark indexes by 2.31 percent annually over the six years ending May 2016. That’s far worse than the typical actively managed fund performed during the same time period. So much for forecasts.
Figure 3.7 US News and World Report’s Recommended US Stock Funds Versus Benchmark Index Funds: Six-Year Profits Made on a $10,000 Investment, May 2010–May 2016
Source: US News and World Reports; portfoliovisualizer.com
Most of these funds won’t appear in a future story of “Mutual Funds to Buy!” Many financial advisers will also pass them over.
Instead, many writers and advisers will search out the funds that beat the indexes during the most recent year or decade. The cycle will repeat. Investors, who follow such suggestions, will be those who pay the price.
Jason Zweig, however, probably said it best. The Wall Street Journal writer published an excellent book, Your Money and Your Brain. In it, he wrote, “The ancient Scythians discouraged frivolous prophecies by burning to death any soothsayer whose predictions failed to come true.”37 He added that investors might be better off if modern forms of divination were held to biblical standards.
His theme echoes what Warren Buffett once said. People will pay a lot more money to be entertained than they will to be educated.
Still, most financial advisers won’t give up. Their livelihood depends on you believing that they can find mutual funds that will beat the market indexes.
Before we were married, my wife Pele was being “helped” by the US-based financial services company Raymond James. They sold her actively managed mutual funds. On top of the standard, hidden mutual fund fees, she was charged an additional 1.75 percent of her account value every year. An ongoing annual fee such as this—called a wrap fee, adviser fee, or account fee—is like a package of arsenic-laced cookies sold at your local health food store. Why did her adviser charge this extra fee? Let’s just say the adviser was servicing my wife the way the infamous Jesse James used to service train passengers—by taking the money and running.
According to a 2007 article published in the US weekly industry newspaper Investment News, Raymond James representatives are rewarded more for generating higher fees:
In the style of a 401(k) plan, the new deferred-compensation program this year gives a bonus of 1 percent to affiliated [Raymond James] reps who produce $450,000 in fees and commissions, a 2 percent bonus for $750,000 producers, and 3 percent for reps and advisers who produce $1 million.38
The article adds that Raymond James pays advisers a percentage point bonus for every additional $500,000 that’s produced for the firm. It tops out at a 10 percent bonus for advisers who produce $3.5 million in fees and commissions. With pilfering incentives like these, salespeople and advisers make out like sultans.
Looking at my wife’s investment portfolio in 2004, after tracking her account’s performance, I calculated that her $200,000 account would have been $20,000 better off if she had been with an index fund over the previous five years, instead of with her adviser’s actively managed mutual funds. In my calculation, I included the 1.75 percent annual “fleecing” fee her adviser charged, on top of the mutual funds’ regular expenses.
When Pele asked her adviser about her account’s relatively poor performance, he suggested some new mutual funds. When Pele asked about index funds, he dismissed the idea. Perhaps he had his eye on a big prize: a Porsche or an Audi convertible. He couldn’t afford either if he bought his client index funds. So he switched her into a group of different actively managed funds that had beaten the indexes over the previous five years—all had Morningstar five-star ratings.
And how did those new funds do from 2004 to 2007? Badly. Despite the strong track records of those funds, they performed poorly, relative to the market indexes, after he selected them for Pele’s account. So Pele fired the guy, and I married Pele.
Over an investment lifetime, it’s a virtual certainty that a portfolio of index funds will beat a portfolio of actively managed mutual funds, after all expenses. But over a one-, three-, or even a five-year period, there’s always a chance that a person’s actively managed funds will outperform the indexes.
At a seminar I gave in 2010, a man I’ll call Charlie, after seeing the returns of an index-based portfolio, said: “My investment adviser has beaten those returns over the past five years.”
That’s possible. But the statistical realities are clear. Over his investment lifetime, the odds are that Charlie’s account will fall far behind an indexed portfolio.
In July 1993, The New York Times decided to run a 20-year contest pitting high-profile financial advisers (and their mutual fund selections) against the returns of the S&P 500 stock market index.
Every three months, the newspaper would report the results, as if the money were invested in tax-free accounts. The advisers were allowed to switch their funds, at no cost, whenever they wished.
What started out as a great publicity coup for these high-profile moneymen quickly turned into what must have felt like a quarterly tarring and feathering. After just seven years, the S&P 500 index was like a Ferrari to the advisers’ Hyundai Sonatas, as revealed in Figure 3.8
Figure 3.8 The New York Times Investment Contest
An initial $50,000 with the index fund in 1993 (compared with the following respective advisers’ mutual fund selections) would have turned into the preceding sums by 2000.39
Mysteriously, after just seven years, The New York Times discontinued the contest. Perhaps the competitive advisers in the study grew tired of the humiliation.
What’s Under the Hood of an Index Fund?
Perhaps the best way to understand the differences between an actively managed mutual fund and an index fund is to put them side by side.
Table 3.1 has a point-by-point comparison.
Table 3.1 Differences between Actively Managed Funds and Index Funds
Actively Managed Mutual Funds Total Stock Market Index Fund
1. A fund manager buys and sells (trades) dozens or hundreds of stocks. The average fund has very few of the same stocks at the end of the year that it held at the beginning of the year. 1. A fund manager buys a large group of stocks—often more than a thousand. More than 96 percent of the stocks are the same from one year to the next. No “trading” occurs. Poor businesses that get dropped f
rom the stock exchange get dropped from the index. New businesses get added.
2. The fund manager and his or her team conduct extensive research. Their high salaries compensate them for this service, adding to the cost of the fund. This added cost is paid by investors. 2. No research is done on individual stocks. A total market index fund can literally be run by a computer with no research costs. Its goal is to virtually own everything on the stock market so there are no “trading” decisions to make.
3. Stock trading (the buying and selling of stocks) within the fund generates commission expenses, which are taken out of the value of the mutual fund. The investors pay for these. 3. Because there’s no “trading” involved, commissions for buying and/or selling are extremely low. The savings are passed down to investors.
4. Trading triggers tax consequences that are passed down to the investor when the fund is held in a taxable account. The taxman sends you a bill. 4. The lack of trading means that, even in a taxable account, capital gains can grow with minimal annual taxation. You keep the taxman at bay.
5. The fund manager focuses on certain stock sizes and sectors. For example, a small-cap fund would own small companies only; a large-cap fund would own large companies only; a value fund would own cheap companies only; a growth fund would own growth companies only. 5. A total stock market index would own stock in every category listed on the left—all wrapped up into one fund—because it owns “the entire stock market.”
6. Companies offering mutual funds have owners who profit from the funds’ fees. More fees raked from investors mean higher profits for the fund company’s owners. 6. A fund company such as Vanguard is a “nonprofit” company. Vanguard is the world’s largest provider of index funds, serving Americans, Australians, and the British. Low-cost indexes are also available to Asians, Canadians, and Europeans.
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