It’s spring here in Chicago (fingers crossed), the baseball season opened yesterday, and the first quarter of the year is in the books. This means that you will be receiving statements from your 401(k) and your various investment accounts. For many investors mutual funds comprise a significant percentage of their portfolio. Here are 4 things to consider when evaluating actively managed mutual fund holdings.
Who’s running the show?
Even with index mutual funds the manager(s) of the fund are a consideration. However the management of the fund is a vital consideration when evaluating an actively managed fund.
Davis New York Venture (DNVYX) is an actively managed large cap blend fund with a long track record of success under two long-tenured co-managers. When one of these co-managers unexpectedly left at the end of 2013 this was a cause of concern in evaluating the fund. The fact that Davis moved quickly to replace this manager with an experienced member of the team at Davis was reassuring. The fund continued its solid relative performance in the first quarter of 2014 after a solid 2013, which was preceded by three very sub-par years. It is too early to tell what impact the management change with have on the long-term performance of the fund and this will bear close scrutiny.
Another example is the veritable soap-opera unfolding at PIMco over the departure of former Co-CEO Mohamed El-Erian. While El-Erian didn’t manage many of PIMco’s funds, I’m guessing the whole situation was a distraction to CEO and founder Bill Gross who is also the manager of the firm’s flagship fund PIMco Total Return (PTTRX). While this situation may not have been the cause, the fund finished in the bottom 15% of its peers in the first quarter. This is on the heels of sub-par performances in calendar 2011 and 2013, though the fund ranks the top 5% of its peers over the trailing ten years all under Bill Gross’ leadership.
It is not uncommon for a fund that has achieved a solid track record over time to see the manager who was responsible for achieving that track record move on. It is important when looking a mutual fund with a stellar track record to understand if the manager(s) responsible for this track record are still on board.
One of the truisms that I’ve noticed over the years is that good performance attracts new money. Even if a top fund is responsible enough to its shareholders to close the doors to new investors before asset bloat sets in, the assets inside the fund might still balloon due to investment gains. Two closed funds that I applaud for putting their shareholders first are Artisan Mid Cap Value (ARTQX) and Sequoia (SEQUX).
I’ve seen several formerly excellent actively managed mutual funds continue to take on new money to detriment of their shareholders. Asset bloat can be a huge issue especially for equity mutual funds that invest in small and mid cap stocks. At some point the managers have trouble putting all of this extra money to work and can be faced with investing in stock with larger market capitalizations. At this point the fund might have the same name, but it is likely a far different fund than it was at its inception.
Closet index funds
According to a 2011 article in Reuters:
“Since the height of the U.S. financial crisis, more funds are playing it safe, hugging their benchmarks and sometimes earning the unwanted reputation as “closet indexers.”
About one-third of U.S. mutual fund assets, amounting to several trillion dollars, are with closet indexers, according to research published last year by Antti Petajisto, a former Yale University professor who now works for BlackRock Inc.
In general, Petajisto defines a closet indexer as a fund with less than 60 percent of its investments differing from its benchmark.”
I was quoted in this 2012 piece in Investment News discussing closet indexers. As the article mentions a fund is considered a closet indexer when its R2 ratio (a measure of correlation) reaches 95 in comparison to its benchmark. In the example of American Funds Growth Fund of America this benchmark index would be the Russell 1000 Growth Index.
The point here is that if you are going to pay up in terms of an actively managed fund’s higher expense ratio, you should receive something in the way of better performance and/or perhaps better downside risk management over and above that which would be delivered by an index mutual fund or ETF.
An example of a an actively managed fund that you might consider being worth its expense ratio is the above-mentioned Sequoia Fund. A hypothetical $10,000 investment in the fund at its inception on 7/15/1970 held through 12/31/13 would be worth $3,891,872. The $10,000 invested in the S&P 500 Index (if this was possible) would have grown to $901,620 over the same period. This fund suffered a much milder loss than did the S&P 500 in 2008 (-27.03% vs. 37.00%) and outgained the index considerably in challenging 2011 (13.19% vs. 2.11%). Sequoia’s R2 ratio is 80.
R2 can be found on a fund’s Morningstar page under the Ratings and Risk section of the page.
Performance is relative
Superior performance is an obvious motivation, but you should always make sure to compare the performance of a given mutual fund to other funds in the same peer group. A good comparison would be to compare a Small Cap Value mutual fund to other funds in this peer group. A comparison to Foreign Large Value fund would be far less useful and in my opinion irrelevant.
Unfortunately superior active mutual funds are often the exception rather than the rule, one reason I make extensive use of index mutual funds and ETFs. However solid, well-run actively managed funds can add to a portfolio. Finding them and monitoring their performance does take work.
Please contact me with any thoughts or suggestions about anything you’ve read here at The Chicago Financial Planner.
Originally posted at https://thechicagofinancialplanner.com/evaluating-active-mutual-funds/