Do you think that the ability to drive a superior car would give you the edge in a car race? In theory, it should. Given the chance to look under the hood and evaluate all engines, you could identify the best performing motor and turn the odds in your favor, right?
Mutual funds run by stock pickers attempt to do just that. Wanna-be market beating managers are sorting through fundamentals and financial statements (looking under the hood) to identify companies that fit their investment objective.
In theory, you’d expect a hand-picked portfolios of stocks to fare better in a bear market than broad, all-encompassing indexes like the Dow Jones Wilshire 5000 or Russell 3000. How have hand-picked stock portfolios been handling the rough terrain?
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As many investors have found out the hard way, active mutual fund managers have fallen short of their job description. A mechanic who couldn’t distinguish between a six and eight cylinder engine would be reduced to working on bicycles. In contrast, a mutual fund manager who can’t beat the market is allowed to keep trying.
According to fund tracker Morningstar, 90% of actively managed midcap stock funds were outperformed by their corresponding index benchmarks. The MidCap SPDRs (AMEX: MDY) and iShares S&P MidCap 400 Index (NYSEarca: IJH) are based on the S&P 400 MidCap Index, a popular measure of mid-sized stocks.
MDY and IJH bested the Fidelity Low Priced Stock Fund (Nasdaq: FLPSX), the largest U.S. MidCap mutual fund, by 10%. In other words, $10,000 invested in FLPSX a year ago is now worth less than $5,000. Curiously, FLPSX is the proud recipient of a four-star rating by Morningstar. I am confused. Is the definition for a four-star rated fund: “may lose more than 50% of its value at any given time?" This makes you wonder how investors unfortunate enough to own one or two-star rated funds did.
A little extra homework reveals that all midcap mutual funds with more than $1 billion in assets lost more money over the past years than MDY while a few other index ETFs matched MDY’s performance. The iShares Russell MidCap Index (NYSEarca: IWR) trumped the long term performance of MDY. On average, midcap indexes outperformed their stock picking counterparts by nearly 7% for the 12 month period ending September 30th.
In the small cap universe, less than 20% of active mutual funds managed to outperform the Russell 2000 or S&P SmallCap 600. ETFs tracking those two indexes include the iShares Russell 2000 Index Fund (NYSEarca: IWM) and iShares S&P SmallCap 600 Index Fund (NYSEarca: IJR).
Did you know that some fund managers actually use the popularity of ETFs to excuse their own underperformance in the small cap sector? Some claim that money pouring into the likes of IWM and IJR drive up prices for thinly traded, index member-stocks while leaving stocks owned by fund managers (outside the index) behind. Oh, if only their ability to pick stocks was as good as their ability to come up with excuses on the fly.
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Without a doubt, large caps is where most of the money (and losses) are these days. Were stock pickers able to select market beating large company stocks? They did slightly, better but far from satisfactory. A meager four out of ten large cap mutual funds were able to beat their large cap benchmark.
Dodge & Cox, one of the most trusted names in the mutual fund business, manages the popular Dodge & Cox Stock Fund (Nasdaq: DODGX) and Dodge & Cox Balanced Fund (Nasdaq: DODBX). Both lagged the S&P 500 (AMEX: SPY) over the 1, 3 and 5 year time frame. DODGX lost 12% more than the S&P 500 since last September.
The B-shares of American Funds Capital Income Builder (Nasdaq: CAIBX) is one of the few funds that did better than the S&P 500. The A-shares of the same fund on the other hand did worse. Yes, a 5.75% front end sales load (A-shares) has been a real drag on performance. The B-shares seem a bargain with “only” a 2.68% deferred sales load and a 1.60% annual expense ratio.
Why anyone would buy and hold loaded mutual funds that can't beat the market is puzzling - especially when you can own the market through low cost ETFs like the SPDRs (AMEX: SPY) or iShares Russell 1000 (NYSEarca: IWB) for 0.10% and 0.15%.
For a few short years the statistics on active mutual funds vs. index funds were severely skewed (in the favor of active funds) by a raging bull market in technology stocks. But it wasn't stock picking acumen that boosted performance. In fact, just about any portfolio of technology stocks selected by a monkey with darts would have outperformed the S&P 500. Bear market conditions have exposed Wall Street's stock picking celebrities and highlighted the validity of inexpensive and boring index investing. |
