With 2008 firmly in the rearview mirror -- despite ongoing trouble in the markets -- it's smart to take a little time to ponder what we might learn from it. A few lessons learned can lead to thousands of dollars saved in the future. Vanguard founder and index fund proponent John Bogle recently talked with The Wall Street Journal about some lessons from 2008, and I found one particularly valuable.
He said, "Mutual funds with superior performance records often falter." This is an often-overlooked truth. Many poor funds have an unusually great year, while truly great funds will occasionally have bad years.
If you need some examples, just think of the S&P 500 index fund, which tanked in 2008 to the tune of 37%. Most other funds also tanked in 2008. How about in other years? Well, Bill Miller's acclaimed Legg Mason Value Trust (LMVTX) gained 43% in 2003, but lagged the market by double digits not only in 2008, but also 2007. A similar fate befell Marty Whitman's Third Avenue Value (TAVFX) fund in 2006. Heck, the well-respected Oakmark Select I (OAKLX) fund lost to the market by nearly 20 percentage points in 2007!
It's always worth listening to Bogle. He pioneered index funds, which are a great grow-wealthy-over-time vehicle, appropriate for most investors. He's not unbiased when it comes to mutual fund musings, but then it's still hard to argue with the advantages of index funds, such as how inexpensive they can be.
Digging for reasons
Once you know and accept the fact that even great funds will have lousy years, you should still pay attention to your funds' performances. Don't shrug off a bad year without looking into it. Good fund managers will offer candid explanations of what went wrong, and when reading their words, you should see how comfortable you are with their reasoning and attitudes.
Let's look at the Oakmark Select I fund as an example. When I clicked over to the Oakmark website recently, I quickly saw one reason for the extreme underperformance of the fund: It's concentrated. As of the end of 2008, it held just 20 different stocks. Most stock funds, by contrast, will hold 100 or more. Concentrating the fund's money in relatively few holdings gives it a shot at significantly outperforming -- or underperforming -- the market. Its top holding was H&R Block (NYSE:HRB), for example, which made up 9% of assets. Yum! Brands (NYSE:YUM) and Discovery Communications (NASDAQ:DISCK) each made up 7%. In other funds, a stake in H&R Block might make up just 0.50% of assets, so that if the stock surges or plunges, it won't have a very meaningful impact on the fund's return. But if almost a tenth of a fund's assets are in a single company's stock, you can be sure that the company's performance will significantly affect the fund.
Management speaks
But what did management have to say? Well, manager Bill Nygren's quarterly commentaries are available on the website, and I found him reiterating to investors that the way the fund invests is behind much of its recent underperformance. It's a value-oriented fund, looking for seriously undervalued companies that are likely to rebound sharply. Its managers often find these firms among the downtrodden, and in recent years, the fund has loaded up on financials, homebuilders, and retailers, all of which have struggled, falling further. Indeed, in late 2007, the fund's top holding was Washington Mutual, with 13% of the fund's assets. The company collapsed, with much of it sold to JPMorgan Chase (NYSE:JPM). (Looking for values in the market? This is a particularly exciting time for that.)
Shortly thereafter, Nygren explained: "Had we not owned Washington Mutual, the Fund would still have shown a loss for the quarter. Other important contributors to that loss were Sprint Nextel (NYSE:S), IMS International and Pulte Homes (NYSE:PHM)." I liked his candor in admitting that it wasn't just one company or investment decision that was to blame. (He also explained that they sold off Sprint Nextel, moving money into Comcast (NASDAQ:CMCSA), in which they saw more promise.)
In some cases, investigating a bad performance in one year can lead you to decide to sell out of a fund. In other cases, you'll come away with a greater understanding of what happened and why, and you'll remain confident of management's skills.
Be realistic
When we invest in mutual funds, we need to have realistic expectations and not get overly excited or despondent over a particularly good or bad year.
It's also good to spend some time thinking about the past in order to learn from it. I did that recently and came up with some lessons that I hadn't learned, or put into practice.
