Indexing Has
Mutual Fund
Industry Worried
Indexing Has
Mutual Fund
Industry Worried
by Andrew Leckey
Why
invest in mutual funds run by portfolio managers when less-costly index
funds that simply mirror the market's moves continue to outperform them?
Why
not take advantage of your own growing investment knowledge and increased
assets by purchasing a group of individual stocks yourself?
Those
two questions many investors are asking themselves these days have the mutual
fund industry tied up in knots. For two years, 90 percent of U.S. diversified
stock fund have failed to outperform the Standard & Poor's 500.
Lack
of success by conventional managers is one reason why Vanguard Group, long-time
champion of a wide range of low-fee index funds that systematically buy
baskets of stocks or bonds, has outgained rivals in attracting new assets.
Even an advertising blitz by Fidelity Investments featuring guru Peter Lynch
and comedians Lily Tomlin and Don Rickles hasn't stemmed the tide.
Many
experts are convinced the rapidly-growing Vanguard 500 Index Fund will soon
catch up to and pass actively-managed $76 billion Fidelity Magellan as the
nation's largest stock fund.
"First
of all, some people have left mutual funds to make their own direct stock
purchases," explained Robert Adler, president of AMG Data Services
in Arcata, CA, which tracks mutual fund flows. "Secondly, some investors
are making a conscious decision that the index of the top 10 stocks, the
top 30, the top 500 or whatever, will do better because liquidity is a primary
issue in today's globalized market."
Here's
evidence of the lack of success most actively-managed funds had in competing
with indexes in the first 11 months of 1998, as tracked by Morningstar Inc:
Only
18 percent of actively-managed large-cap stock funds (304 out of 1,690 funds)
outperformed the S&P 500. The average large-cap fund turned in a 14.87
percent gain, versus 21.57 for the S&P 500.
Fourteen
percent of bond funds (272 of 2,009) outperformed the Lehman Brothers Aggregate
Bond Index. The average bond return was 8.63 percent, compared to 8.35 percent
for the aggregate.
Fifteen
percent of foreign stock funds (83 of 557) outstripped Morgan Stanley Capital
International's Europe, Asia and Far East (EAFE) Index, the benchmark for
non-U.S. stock performance. The average foreign fund turned in an 8.88 percent
gain, versus 15.44 percent for the MSCI EAFE.
The
group representing the best record among managed funds was small cap, with
slightly less than half (351 of 723) outperforming the Russell 2000. The
average small-cap fund's decline of 7.59 percent was slightly less than
the Russell 2000's decline of 8.25 percent.
"It's
imperative the mutual fund industry start making a better case for active
management than it has of late," asserted Don Phillips, president of
Chicago-based Morningstar, which tracks the nation's mutual funds. "Underperformance
is due in part to cost, as well as the fact these funds don't necessarily
look and behave much like the indexes to which they're being compared."
Some
so-called large-cap funds also invest in mid- and small-cap stocks, pulling
down their comparative returns, Phillips noted. In addition, the average
small-cap stock fund's expense ratio of 1.5 percent kept if from outperforming
the pre-expense Russell 2000 by a wider margin. In the case of bond funds,
the difference in return is due almost entirely to expenses.
Among
actively-managed funds that Phillips thinks could beat indexes in 1999 are
the Sequoia Fund (800-686-6884), which through November was beating
the S&P 500 by more than 7 percent; the Clipper Fund (800-776-5033),
a fraction of a percent behind the S&P 500; and Gabelli Asset Fund
(800-422-3554), besting the S&P Mid Cap 400 Index by over 4 percent.
While
it's been almost easy for individuals buying stock in the likes of Microsoft
and America Online to run rings around the average manager, Phillips warns
there are also market periods when the great companies stumble badly. Portfolio
expertise and diversity found in managed funds then comes in handy.
"Mutual
funds are reluctant to get rid of underperforming managers because if they
have to communicate to shareholders that there's been a manager change,
it's going to look like they've been mismanaging money," declared Doug
Fabian, editor and publisher of the Fabian Mutual Fund newsletter
in Huntington Beach, CA "Mutual funds are cash cows for fund companies
and mediocrity has been prevalent."
Among
Fabian's worst fund "lemons" are Merrill Lynch Growth Fund,
with a return 32 percent behind the S&P Mid Cap 400's performance through
November; Mainstay Value Fund Class B, 28 percent behind the S&P;
Berger 100 Fund, 14 percent lower than the S&P; and IDS Equity
Value Fund Class B, trailing the S&P by 16 percent.
"So
many funds have been underperforming and overcharging that investors should
be selling more funds and moving to funds with high value, or to index funds."
Fabian said.
Janus
Funds (800-525-8983) is Fabian's
favorite actively-managed fund company. For example, Janus Twenty was 27
percent ahead of the S&P 500 through November; Janus Mercury 13 percent
ahead of the S&P; and Janus Olympus 11 percent ahead of that index.
Janus Venture was outperforming the Russell 2000 by 15 percent.
Even
leaders of the index fund revolution have been taken aback by recent dramatic
success.
"We
don't think of indexing as being a `home run hitting' type of strategy,
the way it was in 1998," said Gus Sauter, portfolio manager for 15
of Valley Forge, Pa.-based Vanguard Group's index funds. "It is a consistent,
moderate outperforming strategy that over the long haul produces superior
performance."
Indexing
is the tortoise, active management is the hare, Sauter believes. He deems
the 1998 an unusual year in which many portfolio managers underperformed
their respective benchmarks in part because they raised cash during volatility
and therefore didn't quite participate in the market recovery.
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