MINI-COURSE SERIES
MUTUAL FUNDS Part VI
Copyright Š 2012 by Institute of Business & Finance. All rights reserved.
MUTUAL FUNDS
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LOOK AT COSTS Fund expense ratios vary widely and high-cost funds do not have better managers than low cost funds. Funds with higher expense ratios tend to lag cheaper funds. In a 2002 Morningstar study, all of the funds in each Morningstar category were divided into one of four groupings based on their expense ratio in 1996: the highest cost 25%, the next highest cost 25%, the second cheapest 25%, and finally, the cheapest 25%. In all categories, low-cost funds outperformed high-cost funds over the subsequent five-year period. For small company growth funds, for example, the cheapest 25% produced annualized five-year returns of 8.5% between 1996 and 2001, whereas the highest cost 25% produced returns of 7.0%. For large blend funds, the advantage was narrower but still significant—1.2% a year. The Morningstar study also looked at those funds with high expenses and the top 25% returns in the period from 1991 to 1996. The group’s subsequent five-year performance was then compared to the subsequent five-year returns of low-cost funds that landed in their categories’ bottom 25% from 1991 through 1996. Over the ensuing five years, from 1997 through 2001, the cheap funds with poor track records outperformed the high-cost funds with strong past returns. We also look favorably on fund companies that try to keep their trading costs to a bare minimum. American Century, for example, pays less than one cent per share, on average, to execute its trades, while the industry average is five cents per share.
ACTIVE OR PASSIVE MANAGEMENT There are a number of actively managed funds that have consistently outperformed their index benchmarks. And there is evidence indicating that so-called “sophisticated money” directs assets to such managers. The great majority of academic studies are strong advocates of passive management (indexing). Their argument is based on three points: (1) market efficiency, (2) the expense drag of hiring costly analysts, managers, researchers, and traders, and (3) the “hidden” costs of trading—brokerage commissions, impact costs, and bid-ask spreads.
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A number of studies show that indexing tends to be more effective in some investment styles than in others. Funds that focus on large cap U.S. stocks invest in the most closely watched stocks in the world. Funds that venture outside the large cap arena have many more stocks to choose from—there are more than seven hundred U.S., mid cap stocks and more than four thousand small caps to sort through (versus about 250 domestic large cap issues). And more importantly, those stocks receive far less attention from the financial community. So it is more likely that a manager could ferret out an underappreciated gem in the mid or small cap area than in the large cap realm.
BOND MARKETS, INDEXES AND FUNDS The U.S. bond market is valued at roughly $32 trillion (2011); $87 trillion worldwide. The Barclays Aggregate Bond Index is comprised of more than 7,000 different bonds, many of which are so illiquid that fund managers cannot buy, even if they wanted to. Rsquared reflects the percentage change of a fund’s fluctuation that can be explained by the change in its benchmark index. A fund that highly corresponds to its respective index has an R-squared in the high 80s or 90s. For the 10-year period ending September 2006, only two of 15 funds with 10-year R-squared of 98 or higher outperformed the Barclays Aggregate Bond Index. Fund expenses prevented the other 13 possible funds from outperforming the index. The advisor who is seeking index-type returns will have to either choose low expense funds or portfolios that have securities different than their respective index—specifically, high-yield issues. Defaults on U.S. junk bonds for the 2006 calendar year were 1.3%, just under 1.0% for 2007, well below the historical average of 4.5%, as computed by S&P. In November 2009, the junk bond default rate peaked at an annualized rate of 14.5%. The actual default rate for all of 2009 was 13.7%; 151 issuers defaulted on a record $119 billion in bonds. Moody’s expected the default rate to fall to 3.3% by the end of 2010. Surprisingly, for the first five months of 2010, the annualized rate was just 1%; nine issuer defaults, a cumulative total of $1.7 billion (source: Fitch). Before discounting the importance of bonds, consider: From January 1st, 2000 to December 31st, 2002 (three very bad years for most domestic large cap stocks), a $100,000 investment in the S&P 500 fell to $62,406 while a $100,000 investment in the Barclays Aggregate Bond Index grew to $133,466. The following table compares the total return from 7-10 U.S. Treasury bonds versus the S&P 500 for periods ending 12-31-2011.
Total Return: S&P 500 vs. Treasury Bonds [through 12-31-2011] 7-10 Year Treasurys S&P 500
2011 15.6% 2.1%
3 Years 5.9% 14.1%
5 Year 9.1% -0.3%
10 Year 7.1% 2.9% PART VI
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WHEN A FUND CLOSES ITS DOORS When a fund is about to close its doors to new investors there is frequently an onslaught of new money that pours in. The belief is that the fund is almost magical. The reality is something different. A mutual fund advisory service looked at close to 40 funds that closed during a recent 15year period. The funds’ performance was ranked for the three-year period before closing its doors and for the three-year period after new investors were barred. For every fund whose subsequent performance improved, three times as many funds experienced a decline in returns. Compared to the performance of their respective peer groups, the closed fund fell from the top quintile of returns to just below average. Another problem investors face when a fund closes its doors is increased tax inefficiency. When a fund is using inflows of new cash, the need to redeem securities to pay for redemptions or to acquire other securities lessens the triggering of capital gains. One study shows that the average closed fund’s tax efficiency fell 5% after its closing date. One mutual fund family has publicly stated that the negative tax consequences of closing outweigh the pluses. If your client is intent on chasing a fund about to close, there is another course of action—find out what other funds the manager oversees. More likely than not, if there are other offerings, portfolio composition will be similar.
SERIAL CORRELATIONS Serial correlation, also known as the first-order autocorrelation, measures the extent to which the return in one period is related to the return in the next period. Unlike correlation coefficients, a serial correlation only has to do with a single asset category. Serial correlations range from a negative number to positive 1.00. The table below shows serial coefficients of several different asset categories (REITs = real estate, EAFE = foreign stocks, LCS = large cap stocks, SCS = small cap stocks, LTB = long-term U.S. Government bonds, and MTB = med-term U.S. Government bonds). Excluding T-bills, there is virtually
no relationship between returns of most assets from one year to the next.
Serial Correlations Coefficients [1970-2010] REITs EAFE Serial Correlations
0.1
0.1
LCS
SCS
LTB
MTB
T-bills
0.0
0.0
-0.3
0.0
0.8
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THINGS TO DO Your Practice Harley Davidson’s make a special noise that is actually patented. What noise are you making? Without making yourself known, you could be the best-kept secret in your community. Think of ways to make an impression. The Next Installment Your next installment, Part VII, will cover five topics: standard deviation, beta, Rsquared, alpha, and duration. You will receive Part VII in a week. Learn Are you ready to take your practice to the next level? Contact the Institute of Business & Finance (IBF) to learn about one of its five designations: o o o o o
Annuities – Certified Annuity Specialist® (CAS®) Mutual Funds – Certified Fund Specialist® (CFS®) Estate Planning – Certified Estate and Trust Specialist™ (CES™) Retirement Income – Certified Income Specialist™ (CIS™) Taxes – Certified Tax Specialist™ (CTS™)
IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.
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