Hot or Not, Managed Equity Funds not Worth the Expense

February 2, 2009 by  
Filed under Investing

I believe in index funds over managed funds for several reasons. In today’s market, the number one reason is cost.  Almost without exception, fees associated with a managed fund will exceed those charged by an index fund from a low cost provider such as Vanguard.

The other reason is that the majority of managed funds over time do not perform any better than index funds that correspond to the same sector or allocation.  In general, you are not trading higher cost for better performance.  (Full disclosure:  We do own one managed fund – OAKBX – that has done well for us that even though it lost 13% in the past year, I don’t want to sell it and harvest a large capital gain.)

Another problem with managed funds is that some people use them to chase returns.  By this I mean that investors will review the latest list of “hot funds” or “top rated funds” published by a financial website or magazine.  The investor will compare the “hottest funds” (usually a managed fund that got lucky that year or that quarter) to their own, be unhappy by the relative performance data, then swap out, hoping that the hotness will continue.  Some call this “momentum” investing and actually believe in it as a strategy.

We all should know better than to do this.  As in life in general, “hotness” is a fleeting characteristic.  A lot of managed funds reach the highest rankings one year, then fall down in the next, never to reach the top again.  The list of “one hit wonders” among the thousands of mutual and exchange traded funds is probably as long as it is in the entertainment industry.  There is no plastic surgery for a poorly performing managed fund.

The most recent mutual fund performance data reminds us that all of this is true.   This article from the New York Times provides a sobering review of the performance of funds that were top rated by Morningstar and Value Line, two venerable and respected ranking systems.  Looking at theoretical portfolios constructed of the highest ranked funds, they performed no better in 4th quarter 2008 than the overall market.  

The author continued his analysis using portfolios assembled using more complex fund ranking systems, including a momentum investing portfolio.  The result:  Portfolios custom built from the hottest funds performed little or no better than the market as a whole.

I will concede that 4th quarter 2008 was unusual.  Duh.  On the other hand, aren’t the best fund managers supposed to know something that we don’t, causing their funds to get hot and stay hot, at least on relative terms?  If these managers are so smart in the good times, shouldn’t that investing brilliance sustain the fund during the bad times?  Isn’t that why their funds cost more to own?  Apparently not.

That all being said, one of my very good friends (dating way back to my high school years) works for a company that manages funds that you can’t buy on the open market (or without investing substantial cash).  His office sent me some recent performance data on two of his company’s funds.  I was surprised to see 11.3% and 8.95% returns for 2008.  But on closer inspection, these funds were invested in (a) operating loans made to restaurant franchisees; and (b) short term commercial real estate loans.  My hat is off to these fund managers for a job well done.  But funds like these fall into the category of alternative investments for high net worth individuals.  So do hedge funds.  Let’s not forget how most hedge funds did in 2008.

So Mr. ToughMoneyLove will stick with his boring index funds, allocated among non-correlated asset classes.  At least that is my plan until the bear market rally that many anticipate for 2009.  At that point, I may start listening to Harry Dent’s predictions about the next ten investment years, sell into the rally, and give my friend a call.

Image credit:  Myles Davidson

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One Response to “Hot or Not, Managed Equity Funds not Worth the Expense”
  1. I’m like you in the love for index funds. But the Dow lost 40% last year and your managed money only lost 13%. That sounds like the perfect argument for managed money funds.

    I only hold indexes and indexes of indexes, but I do spend a lot of personal research on value investing.

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