Geniuses or Drifters? What are Mutual Fund Managers?
Ron DeLegge, Editor
April 14, 2009
SAN DIEGO (ETFguide.com) – Imagine, for a moment, being served cheap pizza in a fine steak house. Even though the place is highly recommended by dining experts, you aren’t served the steak you ordered. When it comes time to pay the check, you’re subsequently billed for a steak dinner even though you got pizza. How would you feel? Would you ever return to that restaurant again?
Along similar lines, millions of mutual fund investors are being served exactly what they did not order.
For example, many mutual funds labeled as domestic stock funds are investing in foreign securities along with large dosages of cash. Other funds labeled as international stock funds are investing in domestic securities. Other mutual funds specifically state, “Our principle investment objective is to invest in high quality securities for the long-term.” But the annual portfolio turnover for the typical stock fund averages 100%, indicating short-term trading and belying the claim of long-term investing. In other words, these funds are doing the exact opposite of what their outside packaging says! Who in their right mind, would invest their precious savings this way?
Geniuses or Drifters?
The April 8th edition of the Wall Street reported how more and more stock mutual funds are today declaring that “cash is king.” It was pointed out the Mutual Discovery fund (NASDAQ: TEDIX), an $11 billion international stock fund, has almost 30% of its assets parked in cash. The $3 billion Sequoia Fund (NASDAQ: SEQUX) which attempts to ape Warren Buffett's value-investing style, has almost 20% in cash. The $795 million Amana Trust Growth fund (NASDAQ: AMAGX) is roughly 33% invested in cash.
Instead of penalizing the above mutual funds for putting their shareholder’s money in low-yielding cash instead of 95% or more in stocks as they should be doing, Morningstar has rewarded these funds with top rankings. No wonder style drift is such a popular strategy. Even if fund managers have to cheat their way to performance by hogging asset classes or securities they shouldn’t be, they’re blessed with accolades.
If the cash positions in the above mentioned mutual funds are truly this elevated, that would mean the geniuses running them have missed a roughly 20% gain in stocks since the major benchmarks like the DJIA (NYSEArca: DIA) and S&P 500 (NYSEArca: SPY) touched their March lows. Presumably, the geniuses know what they’re doing.
The FPA Capital Fund (NASDAQ: FPPTX) has one of the highest cash levels of any diversified mutual fund. FPA has almost 35% of its assets invested in cash, yet it’s still categorized and labeled as mid-cap value equity fund. Instead of apologizing, the portfolio manager Bob Rodriguez told the Journal, "Maybe now people will realize cash is part of money management, not asset allocation.” Wrong, Bob. Maybe now people will realize that you’re a first class style drifter and a market timer.
Disproving False Theories
The typical sales pitch for active funds is that portfolio managers can protect investors during a bear market by increasing cash while simultaneously lowering exposure to the market. If that’s true, fund managers haven’t been doing a very good job.
Dalbar reports in its Quantitative Analysis of Investor Behavior that in 2008 stock fund investors lost 41.6% compared to the 37.7% loss for the S&P 500 Index. Since the S&P 500 is a fully invested index, with no cash or bonds, it theoretically should’ve performed worse than active funds. But it didn’t. Neither the geniuses nor the drifters, as a group, can consistently beat dumb market indexes even during the worst of times.
Owning Funds Labeled Correctly
If you want your investment portfolio to be invested in cash, fine, but realize it’s an important asset allocation decision you should be making, not someone else. Allowing portfolio managers to make this crucial decision for you will complicate the target or desired asset allocation of your total portfolio.
Here’s a quick example of what I mean: Suppose you own three stock funds, which should represent the 45%* part of your portfolio you’ve committed to domestic stocks. Fund A has 20% in cash and the rest is in domestic stocks. Fund B has 15% invested in international stocks, 10% in cash, and the rest is in domestic stocks. Fund C has 30% in cash, 5% in international stocks and the rest is in domestic stocks. Trick question: What’s your exposure to domestic stocks? It’s not 45%, as you may think or may have been told. Based upon the example above, your true exposure to domestic stocks is 12% off target! Mis-allocated portfolios are not the intelligent way to reach your financial goals.
Finding Better Alternatives
Index ETFs are the solution to avoiding style drift, mutual fund mis-categorization and underperforming fund managers. If you want true representation to the asset classes that the above mentioned funds are supposed to represent, there’s Vanguard FTSE All-World ex-US ETF (NYSEArca: VEU), iShares S&P 400 MidCap Value (NYSEArca: IJJ), and the SPDR Large Cap Value ETF (NYSEArca: ELV).
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*This figure is not a recommendation, but used for illustrative purposes.