Issue # 26                                                                                                                                October 2000

$6 per issue                                                                                                         Annual Subscription $72

             

 

Most of the time I don’t have much fun.  The rest

of the time I don’t have any fun at all.

                                                                       Woody Allen

 

 

Is it My Imagination?

 

          …Or are new funds holding up better than the market?  While stocks are taking some serious lumps, new funds seem to be giving up ground more grudgingly.  Maybe I’m suffering from cognitive dissonance (wishful thinking) like the 80% of motorists who believe they are above average drivers.  While there are plenty of studies – including my own - that show that new funds outperform their peers, most have been done in the context of the long bull market of the last 15 years.  I haven’t seen any studies of whether new funds hold up better during bear markets.  Hopefully, this one (on the Nasdaq, anyway) won’t last long enough to permit a reasonable study.

            One more sell this month: Acorn Twenty reached the 18-month sell point, having provided a 56% return (approximately 35.7% annualized) since inception.  In addition to its geriatric condition, another reason to cash in is that Acorn Management is being acquired by Liberty Financial.  Finally, there is a new-fund replacement (attached) that looks especially promising - I plan to overweight it in managed accounts.

 

Fickle Fund Investors Jettisoning Janus

 

            After 32 consecutive months of pouring multi-billions into Janus funds, the Wall Street Journal reports that investors are now yanking money out – $68.3 million exited in September.   It’s the same old performance-chasing story – the only thing that changes are the fund names.  For the last few years, Janus’ funds have achieved superior returns because they have been highly concentrated in a few handfuls of large growth stocks – mainly technology – that drove the cap-weighted indexes and their own returns.  Janus – belatedly, in my opinion – did close some funds, but being very accommodative, they launched others.  Last year they vacuumed up almost $36 billion and the pace accelerated this year – by mid April, investors, with their eyes glued to the rear view mirror, drove in with another $30 billion – just in time to go over the cliff with the Nasdaq’s 35% drop. 

This year’s experience shows how, once again, the average fund investor consistently manages to achieve lower returns than they very funds he invests in.  The Nasdaq seems determined to test the Spring lows (it’s less-than 10% away) and you can bet your balloons that the lower it goes, the more it will drive jittery Janus investors to sell.

For those who hang on, the worst effect of the tug-of-war between funds and their shareholders is that redemptions coming in over the transom force portfolio managers below deck, where they have to man the bilge pumps.  Instead of being up on the bridge buying stocks at lower prices, managers are forced to sell.  In the case of some funds, forced sales of long-held positions trigger capital gain taxes and hapless newer investors find themselves paying taxes on gains they never had in the first place.

            Critics have long predicted that index funds were capital gain tax time bombs.  However Vanguard’s Gus Sauter has been quoted in numerous places saying that it would take withdrawals in excess of something like 35% of assets before redemptions would begin to trigger gains – and we are a very long way from that.

Because it is mechanistic, the new-fund buy/sell discipline skirts most of these problems.  It clears the obstacle that trips most investors: Market mistiming.  You buy when new funds and sell after six months if they disappoint, and after 18 months when they sparkle.  New funds largely avoid the shareholder- portfolio manager tug-of-war because cash can only go in one direction: In.  And while the relatively short holding periods are not exactly tax efficient, since new funds have no “embedded” capital gains, you don’t end up taxes on somebody else’s profits.   I submit that even if new funds perform no better than their older peers, a disciplined buy/sell strategy that avoids market timing, will provide higher returns than those achieved by the average investor’s mistiming.

 

Morningstar Gazing

 

            In the ongoing quest to prove that they are smarter than Morningstar’s experts, three more experts reported in the Journal of Financial Planning (9/2000) that about 50% of 4- and 5-star funds drop to 3 stars or less at some time during the following 12 months.  The implication:  Why bother?

            Not so fast countered Morningstar’s research director, John Rekenthaler on their website.  While he agreed that the study’s accuracy was “absolutely positively right,” he opined that the study was over too short a period of time and that the “stars are unstable over even short time periods.” 

Then he rolled out the artillery: …”in evaluating a long-term indicator by judging its short-term actions, the authors have not addressed the most important question…If a fund has a high rating when you buy it, what is the chance that it will retain the rating several years later?  In other words, what is the star rating’s long-term prognosis?”   He provided the following statistic: “…if you bought a 4- or 5-star fund a decade ago, you bought a fund that then scored in the top third of the mutual-fund universe.  Over the next decade the fund had a 50% chance of retaining top-third status.  The stars are by no means guaranteed success, but they did stack the odds in the investor’s favor.  Which means that as long as you don’t take their subsequent movements too literally, the stars offer a modest benefit at zero cost.  Could be worse, no?”  

It is worse, actually, because many investors do “take their subsequent movements too literally” – the average holding period is not ten years- it is somewhere between one and two.

“Indexing with Small Cap Stocks-

A Sure Way to Pick Losers”

 

            In June I reported on a study, You Bet Your Assets, I had done using Morningstar Prinicpia Pro for Mutual Funds.  Its purpose was to try and decide when to use index funds and when to use managed funds.  I compared both the frequency and the degree of outperformance of managed small-, mid- and large cap stock funds versus index funds over recent 3-, 5-, 10- and 15-year periods.  The conclusion was that “small-cap funds are most likely to outperform and also most likely to deliver the highest returns versus their target index.”

            Now a study published by the Undiscovered Managers fund family website (undiscoveredmanagers.com) has come to the same conclusion.  In additional to market efficiency, the reason most often cited, the authors believe that the “method of selecting stocks… in the Russell 2000 contains a ‘reverse survivorship bias’” – that is, “the losers survive and the winners depart.”  With statistics covering the last five years, they conclude:

“We believe that the major cause of the reverse survivorship bias in the Russell

2000 is its use of market capitalization as the sole criteria for membership.

As a result, many of the best companies in the index grow out of the benchmark

            and move into the Russell 1000 Index – the index of the 1000 largest U.S.

companies ranked by market capitalization.  The Russell 2000 also holds some

of its biggest losers for extended periods of time before they get small enough to

fall out of the bottom of the index.”

            It’s the index, stupid…