Lipper Research Senior Analyst Don Cassidy on "Business for Breakfast" 1060 KRCN - Urban Legends
Q. Don, before we came on the air, you said you'd like to dispel an "urbanlegend" about mutual funds???A. Right. You know, those so-called urban legends are stories that startgoing around and are repeated, especially with Internet chat-room help, butthey just aren't actually true.
Q. Okay, what is this one about?
A. It was an unsubstantiated number published in a New York City paper andthen was repeated on a popular financial Web site, although the latter atleast questioned its accuracy...
"80% of mutual funds underperform the market."
Q. Yes, we've heard such numbers thrown around. How accurate, or not, isthat?
A. Very not, and of course the answer depends on the period you look atand most significantly the kinds of funds you are talking about.
Q. Okay, take us through a bit of Lipper-type detail and logic...
A. Definitely. And let me start with an analogy. I could say that ShaquilleO'Neill of the Miami Heat is of pretty average height, or that he is verytall. It all depends on what population you compare him to: just NBAcenters, or all adult males in the USA.
Q. Good point!
A. Typically, the people who spread this urban legend about mutual fundstend to make faulty comparisons. Usually, by "the market" they mean the S&P500 Index, which does not represent the whole market by any means! Andright away, any fund--since it has some expenses--will start out at adisadvantage against a cost-free index.
Q. But of course funds do have expenses, and investors have to pay them.So, the pre-adjustment numbers are real.
A. True enough, but you pay a price for someone to manage your money--justas you pay for medical care or an oil change--unless you want to do ityourself!
Q. Okay, but let's put that one about expenses aside...
A. Right. The faulty logic is that not all mutual funds should be comparedwith the S&P 500, since not all funds invest just in (or at all!) large-capstocks.
Putting aside bond and money funds (which are mutual funds):
- Only about 17% of equity mutual funds focus on large-cap stocks.
- Only about 7.5% of equity funds specialize in large-cap core, which is what the S&P 500 is...not growth or value per se.
Q. Okay, so how do the numbers look?
A. Well, as I said, the period you are looking at matters, a lot. If youdid the faulty comparison of all equity funds against the S&P 500, the lastyear a majority of funds did not beat it was way back in 1998!
Q. How could that be? Such a long stretch...
A. Remember, for most recent years small-cap stocks and internationalstocks have beaten the S&P 500, which is large-cap domestic stocks. If yougo back to the past six years, starting with 2000, on average over 61% ofstock funds have beaten the S&P 500. But that's in a non-large-cap period.
Q. But as you say that is not a clean comparison...
A. Right, but it sure shows how old legends never die. If you compare theS&P 500 against large-cap funds, those funds have won in three of the lastnine years. Their worst winning percentage was 30% in 2004. So, 80% beinglosers is just totally false.
Q. You mentioned large-cap core (LCCE) as being the true, bettercomparison?...
A. Right. And there the numbers are not real pretty; but again none is asbad as 80% for even one year. In fact, in 2000 some 62.6% of LCCE fundsbeat the index, and they paid expenses! Anyway, the annual numbers rangefrom that 62.6% down to 21.7% (2004). In six of the most recent nine yearsthe number beating the index has been at least 42%--after expenses.
Q. You mentioned expenses... how about after you adjust for those?
A. Excellent point! When you add back an average total expense ratio ofabout 1%, in five of the past nine years more than half have beaten theindex. The nine-year average is about 45%. Our numbers adjust for averageexpenses, but not for commissions or other trading costs, which are harderto pin down.
Q. Okay. So, how about lately?
A. Well, in 2005, some 61.5% (almost five in eight) of LCCE funds beat theunmanaged S&P 500 Index, if you take out expense drag. This year throughlast Friday, it was 53.8%.
Q. Why is that?
A. As we at Lipper have been forecasting, last year and this year are astock-pickers' or theme-pickers' market. When there are strong themes likeenergy and materials running ahead, active managers can ride those, butindexers can't change their weightings.
Q. Who do you suppose spreads these legends about an 80% failure rate?
A. I have yet to see anyone authoritatively quote real hard data and getthese 80%-type figures, so I don't know anyone by name. But I would not besurprised if the pro-indexing faction were behind it. They focus onexpenses and urge you to buy and hold.
Q. So then, that raises a logical question: how do the S&P 500 Index fundsdo against their benchmark?
A. Well, think about it! They should all trail the index, since they allhave some expenses--100% failure, not 80%. Of course, some cut corners andseem to cheat a little on holding all the stocks in the index, so inpractice some actually do beat their benchmarks.
Q. What should investors make out of all this, Don?
A. First, the more extreme a number you hear, the more careful you shouldbe about accepting it--especially if it does not have a data-sourcecitation. The actual experience for any investor can be a lot better thanthe popular numbers say. If you do not buy and hold forever, you have achoice of reflecting actual market preferences in your portfolio androlling with the tide. People who bought the S&P 500 at the start of 2000are still down about 6%. But they were cutting their costs by buying andhoping!
Second, there are lots of tools out there for selecting good-performingfunds. Some funds just seem to be doggy most of the time. You can eliminatethose easily with a little quick work on good Web sites, such asLipperLeaders.com. So, whatever the raw odds are, you can be in a decentplace to beat them if you work at it. This is not like a casino. There aresome systematically good, and bad, machines-and there are tools to give youpretty fair odds of identifying them!
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Don Cassidy is a Senior Research Analyst at Lipper specializing in fund flows, exchange-traded funds, (ETFs), closed-end funds, equity fund performance, and author of Trading on Volume (McGraw-HIll).
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