Chapter 7
Finding the Best Funds
In This Chapter
Keeping your investment from being whittled away by fees
Looking at a fund’s past and knowing how much risk a fund takes
Getting to know the fund manager and fund family expertise
When you go camping in the wilderness, you can do a number of things to maximize your odds of happiness and success. You can take maps and a GPS navigator to stay on course, good food to keep you nourished, proper clothing to stay dry and warm, and some first-aid stuff in case something awful happens, such as an outbreak of mosquitoes. But no matter how much preparation you do, you still may not have the best of times. You may get sick, trip over a rock and break your leg, or face inclement weather.
And so it is with mutual funds. Although funds can help you reach your financial goals, they come with no guarantees. You can, however, use a number of simple, common-sense criteria to greatly increase your chances of investment success. The issues in this chapter are the main ones you should consider when trying to separate the funds most likely to succeed from those most likely to perform poorly. The mutual funds that I recommend in Chapters 11 through 14 meet these criteria.
Evaluating Gain-Eating Costs
A survey conducted by the Investment Company Institute asked mutual fund buyers what information they reviewed about a fund before purchasing it. Fifth on the list, mentioned by only 43 percent of the respondents, were fees and expenses. Therefore, the majority of fund buyers surveyed — a whopping 57 percent — did not examine the fees and expenses for the funds that they bought.
Additionally, only 27 percent of fund buyers surveyed bothered to look at how much of a load or sales charge was levied by the fund. At the other end of the spectrum, past fund performance was the most cited information reviewed by fund buyers (with 75 percent considering).
Such survey results don’t surprise me. I’ve witnessed investors looking first — and sometimes only — at the prior performance of a fund while completely ignoring fees. Doing so is generally a major mistake.
The charges you pay to buy or sell a fund and the ongoing fund-operating expenses have a big impact on the rate of return you ultimately earn on your investments because fees are deducted from your investment returns. All other things being equal, high fees and other expenses depress your returns. You can and should examine a fund’s expenses and fees before you buy into it. In contrast, past performance is actually a relatively poor indicator of a fund’s likely future returns. (Later in this chapter, I discuss how many of yesterday’s star funds turn into tomorrow’s losers or mediocre performers.) You just can’t know what tomorrow will bring.
Although you have no idea how much of a return you’ll make, you can find out, before buying a fund, how much the fund has been charging in fees — both upfront (in the form of sales commissions) and ongoing (in the form of fund operating expenses). Factor these known reductions in returns into your fund-buying decisions.
Losing the load: Say no to commissions
When the Securities and Exchange Commission (SEC) deregulated brokers’ commissions in 1975, the vast majority — more than 85 percent — of all mutual funds were sold through brokers. The funds they sold are known as load funds. Load simply means commission. When you purchase a load fund through a broker (who often calls himself something other than a broker), the broker is paid a commission (typically ranging from 4 percent to 8.5 percent) out of the amount that you invest.
Thanks in part to the deregulation of brokerage commissions and to the technological revolution that’s taken place over recent decades, the growth of the no-load (commission-free) mutual fund industry took off. Technology provided fund companies with a cost-effective way to handle thousands of accounts for folks like you who don’t have millions of dollars to invest. This fact also enabled fund companies to sell no-load funds directly to investors. Today, no-load funds account for the majority of investors’ mutual fund holdings.
Loads deducted from your investment money are an additional and unnecessary cost when you’re in the market for the best mutual funds. The best no-load funds are every bit as good, if not better, than the best load funds. Today, you can stick with the no-load funds and keep more of your investment dollars working for you.
Not surprisingly, those who have a vested interest in sales loads argue in favor of funds that carry sales loads. Over the years, I’ve heard the content of these broker pitches through readers who write to me or visit my Web site and in counseling clients who came to me for advice.
Be wary of brokers or planners pitching house brands — for example, a Morgan Stanley broker recommending Morgan Stanley mutual funds. The fund industry scandal in the early 2000s further shined the light on this problematic practice. Salespeople often get higher commissions by pushing house brands.
Refuting myths about loads
Brokers have much to say about paying loads, and you should be aware of the arguments they use. Here are a few examples:
Don’t concern yourself with commissions — I get paid by the mutual fund company. It’s true that the mutual fund company pays the broker’s commission. But where do you think this money comes from? From your investment dollars — that’s where. Brokers like to imply that you’re not effectively paying for the commission because it comes from the mutual fund company.
You get what you pay for — load funds have better fund managers. Bunk! Every objective study that I’ve seen shows that paying a load doesn’t get you a better fund manager. Remember, loads wind up in the pockets of the selling brokers and don’t go toward the management of the fund.
What the studies have shown is that on average load funds underperform no-loads. Why? It’s simple: Those commissions paid to the brokers come out of the fund’s returns, although you may not know that from a fund’s published rankings. Some published mutual fund rankings and ratings services completely ignore sales commissions in their calculations of funds’ returns (see Chapter 20).
No-loads have higher ongoing fees. Investment salespeople imply or state that no-loads have to make it up somewhere if they aren’t charging you a sales commission. Although this may sound logical, remember that sales commissions go to the broker, not toward the expenses of managing the fund. Fact is, the reverse is true: Load funds, on average, have higher, not lower, annual operating expenses than no-load funds.
All funds have to spend money to market themselves. Load funds spend money to market themselves both to brokers and to the investing public like you and me. And the better no-load companies, such as those recommended in Chapter 9, benefit from the thousands of investors who call, based on word-of-mouth or other recommendations (such as through this book!), seeking to invest.
No-loads have hidden costs. In this case, a half-truth doesn’t make a whole. Both no-load and load funds incur brokerage transaction costs when securities are bought and sold in the fund. These costs aren’t really “hidden.” They’re disclosed in a fund’s Statement of Additional Information (discussed in Chapter 8), which is part of the fund’s prospectus; however, they’re not included in the calculated annual operating costs for any type of mutual fund, either load or no-load.
No-loads are for do-it-yourself types. People who need help buy load funds. This either/or mentality is trumpeted not only by investment brokers but also by some financial writers and others in the media who sometimes parrot what brokers say to them. If you need advice, you have options. One alternative is to hire a financial adviser and pay a fee for her time to recommend specific no-load mutual funds. No-loads are hardly just for do-it-yourself types (see Chapter 9 for the different types of advisers you may hire), although you can see from this book (after you finish reading it) that you have what it takes to just do it yourself.
I’ll do a financial plan for you to determine your needs. Try as they may, investment salespeople can’t perform objective, conflict-free financial planning. (You should never pay for a “financial plan” from an investment salesperson.) The problem with sales loads is the power of self-interest (discussed in Chapter 9). This issue is rarely talked about, but brokers’ self-interest is even more important than the extra costs you pay. When you buy a load fund through a salesperson, you miss out on the chance to objectively assess whether you should buy a mutual fund at all. Maybe you’d be better off paying debts or investing in something entirely different. But salespeople almost never advise you to pay off your credit cards or your mortgage — or to invest through your company’s retirement plan — instead of buying an investment through them.
I’ve seen too many people get into investments without understanding what they’re buying and what the risks are. People who sell mutual funds usually sell other investments, too. And some of those other products — vehicles such as limited partnerships, cash-value life insurance, annuities, futures, and options — hold the allure (for the salespeople) of high commissions. Salespeople tend to exaggerate the potential rewards and obscure the risks and drawbacks of what they sell and often don’t take the time to educate investors.
I can get you those funds that you’re interested in from the same no-load companies, such as Fidelity. Brokers like to imply that they can sell you basically the same funds that you could buy on your own through no-load companies. However, top no-load companies, such as Vanguard, for example, don’t sell any load funds through brokers. Fidelity sells a series of load funds, called Fidelity Advisor funds, through commission-based brokers. These funds carry hefty upfront sales charges and/or much higher ongoing fees — up to a full 1 percent more per year — than their no-load counterparts.
In recent years, increasing numbers of brokerage firms are offering their customers access to some no-load mutual funds through a service known as a wrap (or managed) account. To get into these funds, you must agree to pay the brokerage firm an annual investment management fee on top of the fees the underlying mutual funds charge. (I explain in Chapter 6 why high-fee wrap accounts aren’t in your best interest.)
The no-loads won’t call you to tell you when to get out of the market or switch funds. True. But far from being a disadvantage, not getting a call to switch funds is actually a plus. Although mutual funds offer daily liquidity, funds are meant to be a longer-term investment.
A broker who stands to gain financially when you trade is hard pressed to be a source of objective advice of when to trade funds. (In Chapter 17, I explain how to evaluate whether to continue holding the funds you own by applying the criteria discussed in this chapter.)
No-loads are impersonal organizations. When you call a no-load fund’s toll-free number, you’ll surely get a different representative every time. Visiting a fund’s Web site is even less personal. If it’s important for you to have a relationship with someone at these firms, however, some representatives give you their names and extensions (just ask) so you can reach them in the future. (Higher balance customers at some fund companies can be assigned a dedicated representative, so inquire.)
A broker can be a personal contact who asks you about your golf game, how your family is doing, and . . . by the way . . . “What’s the phone number of your rich Uncle Johnny?” Independent financial counselors who charge a fee for their time can serve the same role. Likewise, discount brokerage firms such as Charles Schwab, TD Ameritrade, and Fidelity maintain branch offices that offer a personal, local touch if you need and want it.
Exposing loads
The only way to be sure that a fund is truly no-load is to look at the prospectus for the fund. Only there, in black and white and absent of all marketing hype, must the organization tell the truth about its sales charges and other fund fees. (Check out Chapter 8.)
Figure 7-1 is a sample of a typical fee table from a fund prospectus for a load fund. Note that the Class A shares have an upfront 6.5 percent sales commission that’s deducted when you invest your money.
Figure 7-1: How to spot load funds.
The Class B shares don’t have an upfront commission but instead have a deferred sales charge, which decreases over time. However, note that this class can charge you up to an extra 1 percent per year (12b-1 marketing expense fees). Class B shares in this example (as in most real cases) cost you more in the long run because you pay this cost each year as long as you own the fund. Check out the “Hidden loads in alphabet soup: ABCD shares” sidebar earlier in this chapter for even more details on this game of hide the load.
Considering a fund’s operating expenses
One cost of fund ownership that you simply can’t avoid is operating expenses. Every mutual fund — load and no-load — has operational costs: paying the fund manager and research assistants, employing people to answer the phone lines and operate a Web site, printing and mailing prospectuses, buying technology equipment to track all those investments and customer-account balances, and so on.
Running a fund business costs money! Fund fees also include a profit for the fund company. (The brokerage costs that a fund pays to buy and sell securities aren’t included in a fund’s operating expenses. You can find this information in a fund’s Statement of Additional Information, which I discuss in Chapter 8.)
A fund’s operating expenses are quoted as a percentage of the fund’s assets or value. The percentage represents an annual fee or charge. In the case of load funds, this fee is in addition to the stated load. You can find this number in the expenses section of a fund’s prospectus, usually denoted by a line, such as Total Fund Operating Expenses. Or you can call the mutual fund’s toll-free number and ask a representative or dig for the information on most fund companies’ Web sites. I detail what the operating expenses are for the funds recommended in this book.
Some people ask me how the expenses are charged and whether they’re itemized on your fund statement. The answer is that a fund’s operating expenses are essentially invisible to you because they’re deducted before you’re paid any return. Because these expenses are charged on a daily basis, you don’t need to worry about trying to get out of a fund before these fees are deducted.
Although all funds must charge operating expenses, some funds charge much more than others. By picking the right funds, you can minimize the operating expenses you pay. And minimize them you should: Operating expenses come right out of your returns. Higher expenses translate into a lower return to you.
Expenses matter on all types of funds but more on some and less on others:
Expenses are critical on money market mutual funds and are very important on bond funds. These funds are buying securities that are so similar and so efficiently priced in the financial markets. In other words, your expected returns from similar bond and money funds are largely driven by the size of a fund’s operating expenses. This fact has been especially true in recent years when interest rates have gotten low.
With stock funds, expenses are a less important (but still important) factor in picking a fund. Don’t forget that, over time, stocks have averaged returns of about 10 percent per year. So, if one stock fund charges 1.5 percent more in operating expenses than another, you’re giving up an extra 15 percent of your expected annual returns.
Some people argue that stock funds that charge high expenses may be justified in doing so — if they’re able to generate higher rates of return. But there’s no evidence that high-expense stock funds do generate higher returns. In fact, funds with higher operating expenses, on average, tend to produce lower rates of return. This makes sense because operating expenses are deducted from the returns that a fund generates.
But how high is high? You should generally shun a money market or bond fund that charges more than 0.5 percent per year, a U.S. stock fund that charges more than 1 percent per year, or an international or specialty fund that charges more than 1.3 percent per year. Steel yourself against clever marketing brochures and charming salespeople. Read the fine print and walk the other way to a better fund if costs are too high.
If a given fund’s expenses are much higher than its peers, one of two things is usually happening: Either the fund has little money under management — and therefore has a smaller group of investors to bear the management costs — or the fund owners are greedy. Another possibility could be that the fund company is inefficiently managed. (Maybe the company rents high-cost, big-city office space and its telephone reps spend half the day talking with friends!) In any case, you don’t want to be a shareholder of such a fund.
These high-expense funds have another insidious danger built in: In order to produce returns comparable to those of similar funds with lower costs, the manager of such a high-cost fund may take extra risks to overcome the performance drag of high expenses. So on top of reducing a fund’s returns, higher expenses may expose you to greater risk than you desire.
In some cases, a fund (particularly a newer one that’s trying to attract assets) will “reimburse” a portion of its expense ratio in order to show a lower cost. But if (or when) the fund terminates this reimbursement, you’re stuck owning shares in a fund that has higher costs than you intended to pay.
All mutual fund fees — both loads and operating expenses — are disclosed in a fund’s prospectus, which is why obtaining a fund’s prospectus before you buy it is so important. Reviewing the prospectus is especially critical for funds pitched to you by brokers or by brokers who masquerade as “financial planners” and “consultants.” I tell you how to decipher a fund prospectus later in this chapter.
Weighing Performance and Risk
Although a fund’s performance, or its historic rate of return, is certainly an important factor to weigh when selecting a mutual fund, investors tend to overemphasize its importance. Choosing funds on simplistic comparisons of performance numbers is dangerous.
As all mutual fund materials are required to state, past performance is no guarantee of future results. Analysis of historic mutual fund performance proves that some of yesterday’s stars may turn into tomorrow’s skid row bums (as I discuss in the next section, “Star today, also-ran tomorrow”).
Realize that funds with relatively high returns may achieve their results by taking on a lot of risk. Those same funds often take the hardest fall during major market declines. Remember that risk and return go hand in hand; you can’t afford to look at return independent of the risk it took to get there. Before you invest in a fund, make sure you’re comfortable with the level of risk the fund is taking on.
Star today, also-ran tomorrow
Some fund manager may have a fabulous quarter or year or two, ripping up the market with his little growth-stock fund. Suddenly, his face is plastered across the financial magazines; he’s hailed as the next investing genius, and then hundreds of millions and perhaps billions of new investor dollars come pouring into his fund.
Short-term (one year is a short time period) fund performance numbers don’t mean much — luck can be just as big a factor as skill. Also remember that earning much higher returns than other similar funds often means that the manager took a lot of risk. The greater the short-term returns for that fund and manager, the greater the odds of sharp slump.
The history of short-term mutual fund star funds confirms this: Of the number one top-performing stock and bond funds in each of the last 20 years, a whopping 80 percent of them subsequently performed worse than the average fund in their peer group over the next five to ten years! Some of these former number one funds actually went on to become the worst-performing funds in their particular category.
The following sections provide a historic sampling of the many examples of short-term stars becoming tomorrow’s also-rans (and in some cases, downright losers).
Fidelity Growth Strategies
Launched in 1991, Fidelity Growth Strategies invests in medium-size growth companies. The fund performed a little better than the market averages in the early to mid-1990s, and then it dramatically outperformed its peer group in late 1990s.
So, Fidelity promoted the heck out of the fund, and investors piled into it to the tune of nearly $10 billion in 1999. And, Fidelity had some help from articles like the one that ran in the July 18, 1999, issue of The New York Times.
In a positively glowing profile of the fund, and its manager, Erin Sullivan, the Times called Sullivan “. . . the quintessential portfolio manager.” And it added in the following material, which caused investors to send Ms. Sullivan’s fund their investment dollars:
“Ms. Sullivan, 29, has been in charge of the $5.96 billion Fidelity Aggressive Growth fund since April 1997. In that time, the fund has posted total returns of 51.83 percent, annualized, versus 33.16 percent for the Standard & Poor’s 500-stock index. . . . This year through July 15, the fund was up 44.34 percent, nearly tripling the 15.4 percent gain of the S.& P. 500.
Ms. Sullivan goes about her business with the self-assurance of a Harvard graduate, the analytical rigor of a math theoretician, and the vigor of a marathon runner, all of which she is. But she has not entered a marathon race roughly since she took the reins of Aggressive Growth. ‘It’s hard to find time for anything else,’ she said.”
Within months of the Times article, the fund’s fortunes changed. Overloaded with overpriced technology stocks, the fund plunged 84 percent in value from early 2000 to late 2002. It was one of the worst performing funds of the decade just ended with its –9.9 percent per year annualized return.
Van Wagoner Emerging Growth fund
With a mere three years of stellar returns under his belt, Garrett Van Wagoner, manager of the Govett Smaller Companies Fund, decided to cash in on his exploding popularity and start his own money management firm — Van Wagoner Capital Management. Calling Van Wagoner the hottest small company stock picker around, several of the nation’s largest financial magazines recommended investing in his new Emerging Growth fund. Investor cash came flooding in — more than a billion dollars in the fund’s first six months of existence.
The Van Wagoner Emerging Growth fund (since renamed the Embarcadero Small Cap Growth fund) invests in high-flying smaller company growth stocks. In its first full year of operations (1996), the fund posted a respectable total return of nearly 27 percent, placing it within the top 20 percent of funds within its peer group.
In the next year, 1997, the fund dropped by 20 percent and dramatically underperformed its peer group and was among the worst of its peers. Money flowed out, and the fund was largely ignored until 1999 when Van Wagoner piled into technology stocks, which were zooming to the moon. In 1999, this fund produced a total return of a whopping 291 percent (making it the year’s number one stock fund) while assets under management swelled from less than $200 million to nearly $1.5 billion!
Investors who came to Van Wagoner’s party in 1999 were subsequently treated to one of the greatest collapses in the history of the fund industry. Following a drop of 20.9 percent in 2000, the fund posted horrendous losses in the next two years as well — losing 59.7 percent in 2001 and then 64.5 percent in 2002. In fact, the poor investors who bought in at or near the top during late 1999 through early 2000 experienced a stomach-wrenching plunge of more than 90 percent through September 2002. (The fund also had many horrendous years in the 2000s.) See Table 7-1 for how this fund has performed versus its relevant index — the Russell 2000 Growth Index.
|
Table 7-1 Comparing the Van Wagoner Emerging Growth Fund’s Performance |
||
|
Year |
Van Wagoner Emerging Growth Fund Total Return |
Russell 2000 Growth Index Total Return |
|
2000 |
–20.9% |
–22.4% |
|
2001 |
–59.7% |
–9.2% |
|
2002 |
–64.6% |
–30.3% |
|
2003 |
47.2% |
48.5% |
|
2004 |
–16.0% |
14.3% |
|
2005 |
–22.3% |
4.1% |
|
2006 |
10.8% |
13.3% |
|
2007 |
–7.8% |
7.1% |
|
2008 |
–56.8% |
-38.5% |
|
2009 |
12.6% |
34.5% |
Over the past decade, this fund has plunged in value by more than 94 percent! If you invested $10,000 in this fund at its inception in 1996, your investment would’ve shrunk to $1,841; whereas, the same investment in its average peer would’ve grown to $22,383!
Managers Intermediate Mortgage fund
Managed by portfolio manager Worth Bruntjen, Managers Intermediate Mortgage (MIM) was the darling of the moment for almost every mutual fund rating service in 1993. (I talk about rating services in Chapter 20.) It earned kudos because, in its seemingly boring investment universe — government-backed mortgage bonds — it produced an annual rate of return 3 percent higher than that of its peers (who came in it at just 10 percent per year) over the five-year period ending in 1993. By earning 13 percent per year rather than 10 percent, MIM’s performance was about 30 percent better than its peers.
This fund received some of the highest ratings that most mutual fund rating companies allowed for performance, and, supposedly, MIM had “below average” risk. It earned a coveted five-star rating from a leading mutual fund rating service. When interest rates rose sharply in early 1994, the fund got clobbered. It produced a total return of –22 percent in the first half of 1994. This little six-month disaster was enough to bring the fund in dead last among 50 other mortgage bond funds for the five-year period ending June 30, 1994. And the disaster wiped out the above-average returns that this fund had generated over the five previous years.
This fund was able to achieve its temporarily high returns by taking a ton of risk. From where did all the danger come, you ask? The fund invested in complex collateralized mortgage obligations (CMOs), which are pieces of a mortgage. Buying CMOs is like buying chicken parts rather than a whole chicken at the supermarket. A mortgage gets chopped into the different years of principal and/or interest repayments. CMOs are incredibly complicated to understand, even if you surround yourself with computers and investment bankers.
Forbes magazine, which had written a glowing article praising fund manager Bruntjen on January 17, 1994, admitted that its earlier enthusiasm had been excessive — a rare and honorable thing for a financial magazine to do. Forbes said that the magazine had learned from the episode “not to be overly confident in historical statistics, especially those attached to complex investment products. In this case, a volatility measure calculated from a mostly bullish period turned out to be meaningless during a period when the market turned bearish.”
Matterhorn Growth fund
This aggressive stock fund skyrocketed 184 percent in 1975 — the year following the end of one of the worst declines for the stock market since the Great Depression. Since the 1970s, however, this fund has been in the doghouse. It holds the dubious distinction of being the worst stock fund during the 1980s — one of the best decades ever for the stock market.
As money poured out of the fund, its annual operating expenses as a percentage of assets ballooned in excess of 4 percent per year! The fund was finally put out of its misery when it was merged into the CSI Equity fund in 2006.
Apples to apples: Comparing performance numbers
Remember back in school when the teacher handed back exams and you were delighted to get a 92 (unless you’re from an overachieving family)? But then you found out that the average on the exam was a 95. You still may have been pleased, but a lot of air was let out of your balloon.
Mutual fund performance numbers are the same: They don’t mean much until they’re compared to the averages. A 15 percent return sounds great until you find out that the return from the relevant index market average (that invests in similar securities) was 25 percent during the same period.
The trick is picking the correct benchmark for comparison. Dozens of market indexes and fund category averages measure various components of the market. You always want to compare a fund’s returns to its most appropriate benchmark. Comparing the performance of an international stock fund to that of a U.S. stock market index isn’t fair, just as comparing a sixth-grader’s test results on a given test to those of a tenth-grader taking the same test is unfair. (See Chapter 17 for a list of benchmarks and an explanation of what markets they measure.)
Context matters, and mutual fund companies realize this. So in their marketing literature, fund companies usually compare their funds’ returns to selected benchmarks. Keep a wary eye on these comparisons. In the great American advertising tradition, fund companies often pick benchmarks that make it easy for their funds to look good. And in like manner, more than a few investment advisers who manage money do the same, as I discuss in Chapter 24.
Here’s an example of how a fund can make itself look a lot better than it really is.
A number of years ago, the Strong Short-Term Bond Fund (subsequently acquired by Wells Fargo) ran ads claiming to be the number one, short-term bond fund. (I’d show you the ad, but Strong refused to grant permission to reprint it.) The ads featured a 12-month comparison graph that compared the Strong fund’s yield to the average yield on other short-term bond funds. The Strong Short-Term Bond Fund, according to the graph, consistently outperformed the competition by 2 to 2.5 percent!
A bond fund must take a lot more risk to generate a dividend yield this much higher than the competition’s. You should also be suspicious of any bond fund claiming to be this good with an annual operating expense ratio of 0.8 percent. With a yield and expenses that high (as I explain in Chapter 12), a fund has to take higher risks than supposedly comparable funds to make up for the drag of its expenses. And if the fund’s taking that much more risk, then it needs to be compared to its true competition — which, in Strong’s case, are other funds whose investments take similarly high risks. This fund isn’t a bad fund, but it isn’t nearly as good as the ad would’ve had you think.
This fund was on steroids! The Strong Short-Term Bond Fund wasn’t comparable to most other short-term bond funds because
A high percentage of its bonds weren’t high quality. About 40 percent of its bonds were rated BBB or below. (I explain bond credit-quality ratings in Chapter 12.)
Many of its bonds weren’t short-term bonds. The Strong Fund invested in mortgage bonds that are more like intermediate-term bonds.
Strong’s ad also claimed that its bond fund was ranked number one for the year. If a fund takes more risk than the funds it compares itself to, then sure, during particular, brief periods, it can easily end up at the top of the performance charts. But how strong of a long-term performer is this “number one” fund? Over the five years before this ad ran, even including the year the ad was so proud of, Strong’s fund had underperformed most short-term bond funds.
Recognizing Manager Expertise
Much is made of who manages a specific mutual fund. Although the expertise of the individual fund manager is important, a manager isn’t an island unto himself (or herself — more women are becoming fund managers nowadays). (And if the fund manager leaves or retires from the company, you’re left holding the fund.) Earlier in this chapter (see “Star today, also-ran tomorrow”), I explain how a star fund can flare for its moment of investor glory and then easily twinkle down to become just another average or worse-than-average fund. Too many of us seem to want to believe that, in every field of endeavor — sports, entertainment, business — there are superhumans who can walk on water.
It’s true that in the investment world some people shine at what they do. But compared to other fields, the gap between the star investment manager and the average one, over long time periods, typically is small.
If the stocks of large U.S. companies, for example, have increased an average of 13 percent per year over a decade, the money manager focusing on such securities may vault to star status if his fund earns 15 percent over the same time period. Don’t get me wrong: An extra 2 percent per year ain’t nothin’ to sneeze at — especially if you have millions invested. But a 2 percent higher return is a lot smaller than what most people think they can achieve with the best investment managers.
Therefore, the resources and capabilities of the parent company should be equally important in your selection of which funds to invest in. Different companies have different capabilities and levels of expertise with different types of funds. In Chapters 11 through 14, I detail which firms have great reputations in various fund categories. I also recommend individual funds from these various companies.
Avoid fund companies with little mutual fund management experience and success. If you need surgery, you place your trust with a surgeon who’s successfully performed the operation hundreds of times, not to a rookie who’s only seen it on the local cable station. Avoid novelty funds as well. Mutual funds have been around for many decades. Yet not a week goes by without some newfangled fund coming out with a new concept. Most of these ideas come from the fund company’s marketing department, which in some companies has too much clout. Instead of coming up with investments that meet investors’ needs, they come up with gimmicky funds that involve extra risk and that almost always cost extra in their high annual operating expenses.