Wednesday, December 9, 1998
Actively Managed Money
Over the weekend, I was combing through some investment performance records and came across an interesting mutual fund that's consistently managed to keep pace with the market. Better yet, it's done so with minimal trading. Unlike the average fund, which turns over about 77% of its holdings every year, this one makes relatively few transactions. In 1995, just 6.6% of the holdings were changed; in 1996, just 4.8%; in 1997, 6.4%; and so far this year, 8.6%. Low turnover is important because academic studies show that frequent trading correlates with market underperformance.
That's partly because trading expenses come out of investment returns. Related studies also suggest that many investors are simply overconfident; they think they're smarter than they really are. The stocks they sell often do better than the stocks they replace them with. Patient investors may make other mistakes, but they're a little less susceptible to the overconfidence of the market timer. Of course, the tax consequences of frequent trading don't even figure into most studies on the subject, and they can eat away even more at profits.
What's really impressive about this fund, though, is that its managers have shown real skill at picking stocks. They don't just avoid periodic dumping. Because the managers take a largely buy-and-hold approach, they tend to ride their winners. Consider these savvy picks from 1996 alone.
Date Company Bought Current
3/27/96 EMC Corp. (NYSE: EMC) $10 3/4 $82 5/16
3/29/96 WorldCom (Nasdaq: WCOM) $23 $62 21/32
9/5/96 Dell (Nasdaq: DELL) $4 1/4 $68 1/8
9/30/96 Lucent (NYSE: LU) $22 7/8 $99 3/8
12/18/96 Guidant (NYSE: GDT) $28 1/8 $95 9/16
If these weren't literally the five best large cap companies to buy during 1996, then they're right up there. Or consider the stocks the fund cut loose. Even the winners have lost to the market since these trades.
Date Company Sold Current
8/15/96 Ogden (NYSE: OG) $18 3/8 $25 7/16
11/1/96 Yellow (Nasdaq: YELL) $12 $16 7/8
12/31/96 Luby's (NYSE: LUB) $19 7/8 $14 15/16
12/31/96 Shoney's (NYSE: SHN) $7 $1 1/2
Of course, no investor hits a homerun or even a single every time at the plate. The fund picked up Tupperware (NYSE: TUP) for $45 3/4 on May 30, 1996, only to have the stock grow stale to $17 1/8. The managers bought AutoZone (NYSE: AZO) for $27 1/2 on December 31, 1996, but have enjoyed just a short ride to $31 since then. The fund bought Seagate (NYSE: SEG) at $26 3/8 on August 15, 1996, as the drive makers were speeding along. Since then, they have watched it soar, plunge, and now spin back into place at $32. The fund managers also have plenty to beef about when looking over the stocks they cut loose. Ryan's Family Steak House (Nasdaq: RYAN) left the portfolio on December 31, 1996, along with the other restaurant stocks noted above. Yet Ryan's has delivered a mouth-watering rise from $6 7/8 to $13 over the last two years.
Nonetheless, the unheralded managers of this fund have been kicking butt. From 1995 to 1997, they produced a compound annual return of 31.15%. The five-year annual return through 1997 was 20.24%. High-profile money managers like Mario Gabelli may take their seats at Barron's annual roundtable and talk about making people rich, but these guys can't match such performance numbers. This year has proved especially challenging as quick-trigger money runners have been rattled by panics one month and furious rallies the next. Even so, the geniuses behind this fund have matched the market with a 21.24% return thus far in 1998.
How good is that? Recent stats show only 10% of mutual funds beating the Standard & Poor's 500 index this year, about par for the course of late. Of the 50 largest actively managed funds ranked by assets, only four were ahead of the market. Indeed, the average fund this year recently trailed the market average by 14 percentage points! As Barron's Andrew Barry opined a few weeks ago, "[T]his is shaping up as the worst year in memory for active money managers relative to the S&P."
Now that I've got your attention, what is this terrific fund I've discovered? Ok, I confess to trickery. The "fund" is the good old S&P 500 index itself. The genius portfolio managers aren't Nobel laureates. They're none other than the folks at Standard & Poor's Equity Services Group. As with Jethro Tull or Pink Floyd, you know their work but not their names. (Which one's Poor?) So much for star power.
Though everyone talks about indexing as a form of "passive" investing in contrast to "active" money management, that's really not accurate. The S&P 500, like the Dow Jones Industrial Average and the Russell 2000 and virtually any other index you can think of, is under fairly constant revision. We may think of Coca-Cola (NYSE: KO) as the blue-est of blue chip stocks, but Coke wasn't part of the Dow between 1935 and 1987, when Warren Buffett finally started stocking up on the shares. Without Coke, the Dow 9,000 milestone would still be a distant fantasy.
The S&P, of course, differs from the Dow in that it is market value weighted as opposed to price weighted. While a one point move by any Dow stock has the same impact on the DJIA, a one point move by Microsoft (Nasdaq: MSFT), General Electric (NYSE: GE), or any of the other behemoths has a much greater impact on the S&P, just as it would in a real portfolio. And the S&P does work like a portfolio. It's managed to include the leading companies in America's leading industries. In July 1996, Standard & Poor's adopted a classification system breaking the market into 105 industry groups, 11 economic sectors, and 4 major industry sectors. The index includes choice picks from these categories. Currently, industrial companies make up about 75.2% of the firms in the index, with the financials (15.4%), utilities (7.4%) and transportation stocks (2%) filling out the rest. About 92% of the stocks are listed on the New York Stock Exchange.
Mergers and spin-offs trigger many of the changes in the S&P. MCI was replaced by RJR Nabisco (NYSE: RN) after the long-distance provider was folded into the already indexed WorldCom (Nasdaq: WCOM). Gateway (NYSE: GTW) replaced USF&G, which was acquired by St. Paul (NYSE: SPC), also already part of the S&P. But the committee injects its own values as well. It shies away from companies that no longer have their headquarters in the U.S. For example, Chrysler was booted when Daimler-Benz acquired it. Provident (NYSE: PVT) replaced Bay Networks, which was acquired by Northern Telecom (NYSE: NT). Also, despite the widespread belief that America Online (NYSE: AOL) should be added to the index, the S&P committee, part of offline media giant McGraw-Hill (NYSE: MHP), has so far turned a cold shoulder to the top Internet stocks. Yet, given that the index tries to mirror American industry, changes generally strengthen the index since perennial losers are likely to be discarded.
The effect of such active portfolio management hasn't been lost on money managers who use the S&P as a performance yardstick. The ever-interesting hedge fund manager James Cramer noted in TheStreet.com last week that the S&P committee's decisions this year to dump Armco (NYSE: AS), Echo Bay Mines (AMEX: ECO), John H. Harland (NYSE: JH), and Charming Shoppes (Nasdaq: CHRS) in favor of "more robust" companies that make the index harder to beat puts "the lie to the notion of a brain-dead index." But Cramer concluded with some uncharacteristic griping. "We don't want to measure ourselves against some benchmark that represents another manager's 500 favorite stocks, that deducts the stinkers and adds winners with some regularity," he wrote. "That's just not fair."
In fact, it is fair, or at least fair enough. Since 1988, the committee hasn't been restricted to including only a set number of companies from each industry. It's had leeway to react to economic and stock market changes. So the index has operated under the current rules for over a decade. Money managers are free to follow a similar course if they think it will produce better results than what they've been getting. The truth is that a benchmark that didn't try to keep up with the changing business environment would be pretty much worthless.
Of course, what Cramer's observations ultimately suggest is that a mutual fund indexed to the S&P 500 is actually a great deal for average investors. These funds give you the chance to buy into a group of America's largest, best, most representative companies whose membership is constantly revised to ensure that's the case. That does make for one heck of a benchmark and one awesome investment opportunity.
-- Cash-King Portfolio, 12/01/98: Eyes on Gabelli
-- The Evening News 06/10/98: Buy-and-Hold Beats Rapid Trading
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