There are two general lines of thought when it comes to picking funds. Indexers expect that they will do better than active fund investors by minimizing fees. On the other hand, active fund investors postulate that they will do better by relying on the skill of expert portfolio managers.
Either way, costs matter and fund fees are largely combined into a fund's Management Expense Ratio or MER. To see how fees affect performance consider an index fund with a MER of 0.5% where the underlying index has risen by 10%. In this case the index investor's return would be 10%, less 0.5%, or 9.5%. Similarly, if an active fund charges a MER of 2.5% and its clever portfolio manager gained 12% then the investor would achieve a gain of 9.5% (12% less 2.5%).
The average equity fund charges a MER of about 2.5% and at first blush this rate might not seem to be very high. After all, until recently, many fund investors were rewarded by returns of 20% and 2.5% seems like a small price to pay. However, under most circumstances 2.5% is actually quite high. Let's consider putting $100,000 into both Fund A (with a MER of 0.5%) and Fund B (with a MER of 2.5%). In the next five years both funds gain the same amount before fees and achieve annual returns of 10%, 5%, -5%, 15% and 0%. After the five years Fund A's investors take home $123,194 and Fund B's investors get $111,797. The 2% fee difference nets $11,397 more for the low cost investor.
Indexers rightly point out that a 2% cost difference is large and they are skeptical that skill counts for much. For active fund investors to outperform they must select managers who can beat the fee differential.
Most active fund investors pick their funds by focusing on past performance. Various mutual fund rating guides cater to this desire and use past performance as their sole selection criteria. More advanced services tweak things a bit by incorporating fund volatility or some measure of how consistent returns were. However, in the end it is all about past prices. If a fund has done well then it is assumed that the manager has skill and the role of luck is discounted.
Regrettably, past performance has long been shown to be a poor predictor of future success when it comes to mutual funds. With the aid of globefund.com I looked at the top 10 performing Canadian growth funds of 1999. All had achieved stunning gains of over 31% but investing at the end of 1999 would have been a poor decision. In 2000 eight out of ten of the funds did worse than average and only two did marginally better. The ten 1999 winners fared even worse in 2001 (January 1 to December 7) with nine out of ten doing worse than average. It should be noted that the one fund that did better than average in 2001 was not one of the two that did better than average in 2000. This example provides just a taste of the evidence against buying the best past performers and is illustrative of the dangers associated with performance chasing.
Should performance be totally ignored? No, it turns out that really bad performance is a fairly good indicator of unskilled management. If a fund has been in the bottom 25% of performers with a high degree of regularity it is best avoided. Regrettably you can only weed out about 10% to 15% of managers this way and you need a long track record of poor performance to do so. You can cut out the truly horrible managers but it is hard to tell the difference between mediocre and good. This is a significant problem if you are relying on good management to earn 2% more than average management.
Taxes are also a big issue for regular investment accounts. Consider a portfolio manager who gains 15% annually before taxes over a 20-year period and pays 27% on realized gains. If they didn't buy or sell a single stock in that 20-year period then they would have an after tax-return of 15%. However, if they bought and sold their entire portfolio each year then they would have achieved a much lower return of 11% after tax (see www.tweedy.com). Tax minimization is a key advantage of the buy-and-hold approach and is ignored by many actively managed mutual funds. Recently funds have been forced to publish portfolio turnover in their prospectuses. Lower turnover funds are generally better performers because they trigger less tax and incur lower brokerage fees.
When selecting active mutual funds, investors should first minimize fees. This means a low MER, low turnover and no loads. Secondly, managers with a horrible longterm track record should be shown the door. This straightforward approach produces a short list of frugal funds some of which are shown in Table 1. I have taken the liberty of assigning a star rating to each fund with high star funds charging particularly low fees and achieving low turnover.
By sticking to low cost funds the active investor benefits from the main advantage of indexing and may gain from professional management. Will these funds outperform? It is hard to say for sure but I think that they have a better than average chance.
A complete list of frugal funds is available on request.
Date: Jan 2002
|Disclaimers: Consult with a qualified investment adviser before trading. Past performance is a poor indicator of future performance. The information on this site, and in its related newsletters, is not intended to be, nor does it constitute, financial advice or recommendations. The information on this site is in no way guaranteed for completeness, accuracy or in any other way. More...