Fool.com: In Search of Foolish Funds[Fool on the Hill] June 16, 2000

FOOL ON THE HILL
An Investment Opinion

In Search of Foolish Funds

By Matt Richey (TMF Verve)
June 16, 2000

What I'm about to tell you is totally contrary to the "always buy an index fund" advice typically offered among these pages. The Fool's typical logic on this subject has been that if you want to put some elbow-grease into the investment process and beat the market's average return, then you might as well focus your efforts on individual stocks. Otherwise, just buy an index fund. The good ol' S&P 500 Index has achieved a 20-year average annual return better than 18%, and four out of five actively managed funds have underperformed that benchmark over the past 20 years (thanks, Lipper). So, why even try to beat the index? Well, call me a fool, but I propose that Foolish mutual funds do exist, and further, they're not even that tough to dig up.

Before I show you how I found a few gems of the mutual fund world, we need to first examine the Fool's traditional argument against actively managed funds. In our Overview to Mutual Fund Investing, the Fool slams mutual funds for a variety of ill conditions: the tendency to underperform the S&P Index while incurring significant costs to do so; a fund's holdings are not always known to its shareholders; the typical dilution of good ideas found in funds that hold hundreds of stocks; and the hidden costs of loads, 12b-1 fees, and taxes. These criticisms are all quite valid.

But consider now this alternative viewpoint:

My Contrary Logic in favor of Certain Foolish Mutual Funds
The Foolishness of Historical Index Outperformance. Sure, most fund managers are full of hot air with their beta-polluted Modern Portfolio Theory. The 80% of funds that have underperformed the S&P 500 over the past 20 years qualify as Wise in the worst way and should be rightly shunned. There are, however, a minority of funds that have a great track record of outperformance, achieved by seasoned managers with a multiyear tenure.

Control Through Low Turnover. You have greater control over what you're invested in with a mutual fund if the fund has a history of low turnover. Turnover tells us what percentage of the fund's assets were sold during the past year. This number gives us an idea of how often the fund jumps from one investment idea to the next. A Foolish fund will have low turnover, and consequently, you'll have more reliable knowledge of what you're actually invested in. Additionally, a low turnover fund will also be highly tax-efficient because it will incur less-frequent capital gains distributions. In essence, a Foolish fund is actually quite passive even though it carries the "actively managed" label.

Lack of Idea Dilution Through Concentrated Holdings. Some actively managed funds are just overpriced replicas of the S&P 500. They have as much diversification as the index, but without the low costs. This is a classic ploy of the Wise. Alternatively, a Foolish fund utilizes a concentrated strategy, investing in only its best ideas, ideally under 50 stocks total.

Reasonable Costs Through Low Expense Ratios and No Loads. Today's mutual fund information websites make it easy to uncover the costs of a fund. Look for funds with no loads (i.e., no sales charges) and an expense ratio below 1%. This keeps your investment costs within classic Foolish guidelines.


Finding Foolish funds that meet these criteria is a cinch. I spent no more than an hour going through the following routine. The search for Foolish Funds begins with Morningstar's excellent Fund Selector screening tool. Below are the criteria I utilized in my search:

  • Fund group: Domestic Stock
    Domestic because international investing is its own can of worms.
  • Management tenure greater than or equal to: 3 Years
    We want to be sure the historical track record can reasonably be attributed to the guy or gal currently at the fund's helm.
  • Minimum initial purchase less than or equal to: $2000
    I want any qualifying funds to be available for a $2000 IRA contribution.
  • No-load funds only
    A load, or sales charge of typically 2-5%, is an expense NEVER worth paying. There are too many good no-load funds that don't eat away at your principal before you've even started compounding your savings.
  • Expense ratio less than or equal to: 1.00%
    This is a long-held Foolish guideline. Over the long-term, keeping costs low is essential to beating the market's average return. Further, each percent of return when compounded for decades can add up to literally hundreds of thousands of dollars.
  • 5-year return greater than: S&P 500
    The S&P 500 is our benchmark. Utilize the old adage "If you can't beat 'em, join 'em." That's the way Fools approach the S&P 500.
  • Turnover less than: 25%
    A Fool makes investments carefully and with the aim of holding for many years. Turnover of 25% implies a portfolio that's only revamped once every four years (calculation: 1 / 0.25 = 4). Such low turnover as this also gives you a more reliable indication that a fund's top holdings (as reported in the fund's literature) aren't just the result of end-of-quarter "window dressing."

    With these criteria in place, here's a summary of what the screen spit out, along with the Vanguard 500 Index Fund (one of the best S&P 500 index funds) for comparison:
                         5-year    Annual   Expense
    Fund                Av. Ret.  Turnover   Ratio
    White Oak Growth     39.06%       6%     1.00%
    Pin Oak Aggressive   38.04%      10%     1.00%
    Harbor Growth        30.63%      23%     1.00%
    NE Investors Gr.     27.71%      19%     0.94%
    Selected American    25.96%      21%     0.93%
    Vanguard 500 Index   24.26%       6%     0.18%
    
    Only five funds, yes, but look at the quality of those numbers. An investment of $10,000 in the White Oak fund five years ago is now $49,452 (net of fees, but pre-tax). By way of comparison, that same $10,000 in the Vanguard 500 would be $29,359. Clearly, the rewards of finding a Foolish fund can be well worth the effort.

    Since two of the funds represented here are from the Oak Associates fund family, I decided to carry my research a step farther and investigate their website. I found an impressively Foolish investment philosophy, summarized as follows:
    • Invest in good companies with good ideas.
    • Keep it simple. Invest for the long-term.
    • Sell when a better idea comes along.
    • Concentrate on technology, healthcare, and financial services.
    Those are Foolish tenets, if there ever were any! Here are a few other key snippets that stood out:

    "Our investment philosophy is straightforward: invest in companies that execute the best ideas in their industries. The market rewards well-managed companies in growth sectors of the economy."

    "The key ingredients to Oak's successful investment approach have been our concentration in best ideas, our buy and hold philosophy, and low turnover."

    "We keep our portfolios small and manageable. All portfolios are fully invested, averaging between 15-22 issues."

    These Foolish statements are confirmed by Oak's track record of low turnover, low expenses, and market outperformance. To be sure, Oak or any other mutual fund must be watched and held accountable to its promises. But in the final analysis, Foolish equity mutual funds DO exist, and it didn't take me more than an hour to uncover some real beauts.

    In conclusion, I still believe in the following Foolish truths: 1) A hand-crafted portfolio of individual stocks remains the ultimate low-cost, high-reward investment vehicle for those who enjoy the process of studying businesses; 2) index funds are the way to go for those who want a totally hands-off solution to investing.

    But what about the class of investors with less of an inclination to follow individual stocks, but with a willingness to spend a little time researching the Foolishness of various funds? For those investors, I think well-selected mutual funds can be a fantastic choice.

    What do you think? Have I committed Foolish heresy? Come share your thoughts on the Fool on the Hill discussion board, linked below.

    --Matt Richey, TMFVerve on the boards