FundAlarm - Highlights & Commentary Archive

Highlights and Commentary

By Roy Weitz

(Originally posted March 1, 2005) [Archive Table of Contents]

Funds for all seasons, and funds for none: Five years ago this month, the stock market bubble burst.....Today's stock market is a very different place than it was in March 2000, yet some funds that were top performers five years ago have been able to adapt to this new market, and maintain their benchmark-beating ways.....On the other hand, some funds can't seem to find a market they like: They were underperformers at the beginning of the decade, and they are still laggards today.....The accompanying page lists all NO-ALARM (Honor Roll) funds in this month's database that were also NO-ALARM in March 2000.....At the other end of the spectrum, the accompanying page also lists all of today's 3-ALARM funds that were 3-ALARM five years ago.....Here's a short list of ten relatively large funds: Five of them are perennial stars (NO-ALARM), and five are perennial bottom feeders (3-ALARM).....Can you tell which is which?

1. Oppenheimer Main St B (OMSBX)

2. American Funds Growth Fund A (AGTHX)

3. Scudder Total Return A (KTRAX)

4. Fidelity Contrafund (FCNTX)

5. AXP Stock A (INSTX)

6. Vanguard Primecap (VPMCX)

7. T. Rowe Price New America Gr (PRWAX)

8. Julius Baer Intl Eqty A (BJBIX)

9. Calvert Social Inv Bal A (CSIFX)

10. Excelsior Value & Restruct (UMBIX)View the entire list

The odd numbers are the 3-ALARM funds,
the even numbers are the NO-ALARM funds

Last October, we noted that Fidelity was lowering the management fee to ten basis points (0.10%) on several of its index funds, in a direct attack on Vanguard's indexing business.....It took a while, but Vanguard CEO John Brennan has finally responded to Fidelity's move.....In an "interview" posted on Vanguard's Web site, Brennan refers to recent fee reductions by Vanguard's "competitors" as (variously) "just marketing," "a marketing ploy," and "opportunistic marketing".....We tend to agree with Brennan, and we doubt that Fidelity's fee reductions (technically, fee waivers) will stick for very long..... But Brennan needs to be careful when he sneers at other firms for their marketing efforts.....As "Ed" recently pointed out, on the FundAlarm Discussion Board, "the biggest marketing ploy out there is Vanguard's 'unique structure,' the one that misleads investors into believing they own Vanguard".....We're not sure this is the biggest marketing ploy out there, but Ed definitely has a point: Vanguard gets a huge amount of marketing mileage by claiming to provide its services "at cost," as well as by hyping its "mutual" structure.....In reality, "at cost" is a very flexible concept, and Vanguard investors have no rights that even vaguely resemble those of a business owner (for example, Vanguard investors have no right to know how much their employees are paid, including Brennan himself).....Before all of you Vanguard fans send us a bunch of irate e-mails, please read on: Yes, we agree, Vanguard is still one of the best citizens in an industry with many suspect characters.....But Vanguard also has benefited from a long, free marketing ride, and Brennan should consider that fact before he self-righteously disses the competition.

Eliot Spitzer, New York's crusading attorney general, blasted the SEC at a recent industry conference, declaring that the SEC "hired gnomes rather than people who think"*.....SEC Chairman William Donaldson reportedly "turned as red as his pointy little hat," but had no public reaction to Spitzer's comment.

* "Spitzer's Latest Jab at SEC Draws Cries of Foul," Chris Frankie, ignites.com, February 11, 2005

Can the first class-action lawsuit be far behind? If you put money in a principal-protected fund, and keep it there for the required amount of time (typically, five to seven years), you'll always get back at least your initial investment.....Since principal-protected funds are allowed to invest in common stocks, this seems like a classic win-win proposition for investors: At best, you'll earn the stock market rate of return, at worst you'll get back your principal (less fees and sales commissions)....The catch, of course, is that while a principal-protected fund theoretically can invest all of its assets in the stock market, in the real world most principal-protected funds hold only a minuscule stock position (otherwise, the fund might have a hard time meeting its return-of-principal guarantee).....In 2004 and 2003, the average stock fund gained 12% and 33%, respectively, while the average principal-protected fund gained just 2% and 5%, reflecting the minimal stock market exposure of most principal-protected funds.....Principal-protected shareholders are starting to feel left out of the stock-market party, and principal-protected funds are starting to bleed assets (about $1.5 billion, or 20 percent of total peak assets, was pulled out last year alone).....One broker who sold principal-protected funds complains that 20-20 hindsight is responsible for today's unhappiness with the vehicle, and he says that principal-protected funds served a legitimate investment purpose during the bear market*.....We disagree: From the day the first principal-protected fund was rolled out, it was clear that (a) many investors wouldn't understand what they were buying and (b) this was an investment vehicle guaranteed to be plagued by 20-20 hindsight, once the stock market recovered.....The companies that marketed principal-protection funds have earned some nice fees.....Now, they can probably get ready to give back some of that money to their lawyers.
* "'Safer' Mutual Funds Look Sorry," Ian McDonald, The Wall Street Journal, January 25, 2005

If we gave you a blind choice of three mutual funds - Fund X, Fund Y, and Fund Z -- and we told you that each of the three had generated an average annualized return of about 15% over the past five years, you might think that the choice was a no-brainer.....After all, with a return like that, each fund would be in the top 5% of all mutual funds, so how could you go wrong?

	Average annualized return (Calendar years 2000-2004)
Fund X	14.98%
Fund Y	14.98%
Fund Z	14.99%

Now, let's say we give you another choice of three funds - Fund A, Fund B, and Fund C -- and this time we give you their total return percentages for each of the past five calendar years, as follows:

	Total return for the year (%):
	2000	2001	2002	2003	2004
Fund A	14.11	6.53	12.21	30.68	12.72
Fund B	0.00	0.00	0.00	0.00	101.00
Fund C	-8.00	23.86	-17.35	108.93	2.93

This chart gives you more information than the previous chart, and we suspect that most people would have an easier time distinguishing among the three funds: Fund B seems ridiculously volatile, Fund C seems only slightly less volatile, and Fund A looks like the clear winner, with no losing years and a nice, smooth ride all the way.....Now, let's complete the picture, by showing you the average annualized return for each of these funds:

	Total return for the year (%):					Average annualized return (Calendar years 2000-2004)
	2000	2001	2002	2003	2004	Average annualized return (Calendar years 2000-2004)
*Fund A (also Fund X)*	14.11	6.53	12.21	30.68	12.72	14.98%
*Fund B (also Fund Y)*	0.00	0.00	0.00	0.00	101.00	14.98%*
*Fund C (also Fund Z)*	-8.00	23.86	-17.35	108.93	2.93	14.99%

* Yes, this is correct: The annualizing calculation links yearly
returns, and doesn't just take an arithmetic average (i.e., 101/5).

In other words, Funds A, B and C are equivalent to Funds X, Y and Z.....Or, to put it another way, three funds that are almost impossible to distinguish based solely on their annualized return (X, Y and Z) are quite easy to distinguish when you look at how those returns were achieved.....The lesson here is simple, but worth repeating: When you screen funds by performance alone, you're potentially overlooking huge variations in how that performance was achieved.....It's always a good idea to look at each annual return that is factored into a fund's multi-year annualized returns.....Then, you can decide if you are comfortable with the pattern of potential ups and downs, and perhaps avoid unpleasant surprises.

Some additional points about the item above:

When we talk about the "ups and downs" of a fund, we're talking about the fund's "volatility" of return, or its "risk." There are traditional measures of risk, such as standard deviation and the Sharpe ratio, that an investor could have consulted when faced with a choice among the three funds above (or any other funds). But it can be difficult (or impossible) for the average fund investor to translate these mathematical measures of risk into a real-world decision-making tool, and we've always felt that traditional risk measures leave a lot to be desired.
Fund A and Fund C are real funds: Fund A is Fidelity Advisor Emerging Markets Inc Instl (FMKIX) and Fund C is Oberweis Micro-Cap (OBMCX). Fund B is fictitious, and we made up the annual returns (obviously) to emphasize our point.
If you were comparing funds with a similar style and strategy (say, three small-cap growth funds), it's unlikely that you would get annual returns that varied as dramatically as the funds used in our example. But even when comparing similar funds, the pattern of historical annual returns can be quite different, and quite revealing.

When XYZ fund company wants a brokerage firm to push XYZ mutual funds, XYZ fund company typically pays the broker a bribe, which is euphemistically referred to as a "revenue-sharing payment".....Recently, federal and state regulators have been gunning for revenue-sharing payments, attacking them from the brokerage side (that was the crux of the recent Edward Jones case) as well as from the fund company side.....Fund companies that make revenue-sharing payments typically defend themselves by pointing to "disclosures" they have made in fund Statements of Additional Information, but these disclosures have mostly been a sham: A few vague, legalistic sentences buried deep in a document that the average investor never sees, and probably couldn't find even if he or she wanted to.....Recently, spurred on by their lawyers, fund companies have been beefing up their revenue-sharing disclosures.....A good case in point is the old and new revenue-sharing disclosure for Fidelity Magellan ("FDC," below, stands for "Fidelity Distributors Corporation"):

The old revenue-sharing disclosure for Fidelity Magellan		The new revenue-sharing disclosure for Fidelity Magellan
"FDC may compensate intermediaries that satisfy certain criteria established from time to time by FDC relating to the level or type of services provided by the intermediary, the sale or expected sale of significant amounts of shares, or other factors."		"FDC or an affiliate may compensate intermediaries that distribute and/or service investors in the fund, or, at the direction of a retirement plan's named fiduciary, make payments to intermediaries for certain plan expenses or otherwise for the benefit of plan participants and beneficiaries. A number of factors are considered in determining whether to pay these additional amounts. In certain situations, such factors may include, without limitation, the level or type of services provided by the intermediary, the level or expected level of assets or sales of shares, the placing of the funds on a preferred or recommended fund list, access to an intermediary's personnel, and other factors. In addition to such payments, FDC or an affiliate may offer other incentives in the form of sponsorship of educational or client seminars relating to current products and issues, assistance in training and educating the intermediaries' personnel, and/or payments of costs and expenses associated with attendance at seminars, including travel, lodging, entertainment and meals. FDC anticipates that payments will be made to hundreds of intermediaries, including some of the largest broker-dealers and other financial firms, and these payments may be significant. As permitted by SEC and the National Association of Securities Dealers rules and other applicable laws and regulations, FDC may pay or allow other incentives or payments to intermediaries. These additional payments, which are sometimes referred to as "revenue sharing," may represent a premium over payments made by other fund families, and investment professionals may have an added incentive to sell or recommend a fund or a share class over others offered by competing fund families."

The new disclosure still leaves much to be desired, but at least it uses the term "revenue sharing," and a savvy, determined investor would at least have a chance of figuring out what Fidelity is trying to say.....But the new disclosure also highlights the total inadequacy of the old disclosure (and here Fidelity isn't alone among fund companies).....If Fidelity ever tries to make the case that its old revenue-sharing disclosure was adequate - say, in a lawsuit, or in response to an SEC investigation -- the new disclosure seems like a pretty good piece of evidence to the contrary.
Fidelity's new revenue-sharing disclosure was first pointed out by Laura Johannes, in The Wall Street Journal "Fund Track" column, January 31, 2005

Fortune magazine recently published its annual list of the "100 best companies to work for," and two mutual fund firms made the cut: American Century (#26), and Vanguard (#72).....Fortune notes that American Century

"...[gave] every employee...a $1,000 cash bonus in '03 to celebrate success after three years of down markets. The company puts up to 13% of each employee's salary into a profit-sharing plan, regardless of employee contribution."

At Vanguard, according to Fortune,

"staffers get the rooms with a view....[while] officers sit in interior spaces. The firm offers an onsite MBA at all three of its U.S. locations..."

Of course, there are also fund companies that aren't so great to work for.....Here's FundAlarm's exclusive lowdown on the five fund companies where you'd least like to spend your time:

Columbia:

"Ever since fund managers allowed market timers to steal money from kids (Columbia Young Investor), employees leaving the office have been harassed by gangs of angry children."

Fidelity:

"On orders of CEO Edward Johnson, workers who don't hew to the Republican party line must watch videotapes of John Kerry campaign speeches during their lunch hour."

Janus:

"'Are we a growth firm or a value firm? Are we geniuses or fools? Are we humble, or still arrogant?' Firm's recent, split personality causes many employees to seek mental health care."

Legg Mason:

"Bill Miller needs a glass of water. Bill Miller has noted a relationship between the average salary of the Baltimore Orioles and the Gross National Product. Bill Miller wants to talk about similarities between elephant behavior and the stock market. Bill Miller has a minor case of gas. It gets old fast."

PBHG:

"Employees enjoy working for a well-respected, scandal-free firm, with a long history of fiduciary responsibility and manager continuity. No, wait, that's some other place. "

Briefly noted:

John Hancock Funds was the first to do it, Vanguard did it a few years ago, and Integrity Mutual Funds did it within the past few months: All of these firms have "adopted" mutual funds, and the trend is on the rise .....For a small fund from an independent firm, being adopted is a way to tap into a distribution network (read: marketing and sales staff), which means that the fund's assets under management often grow dramatically.....The adopted fund manager stays in place, and must share its management fee with the company that initiated the adoption, but earning a smaller piece from a bigger asset pie is often more rewarding than going it alone.....Adoption brings pretty much zero benefit to fund investors, but since when did that matter?.....Both adopting and adopted companies like it, so expect the trend to continue in 2005 and beyond.
"Adoptions find good match between small, large firms," Cecily O'Connor, Pensions & Investment, January 10, 2005
Mutual fund "oops" #797: Back in April 2004, Putnam was desperate to get the scandal monkey off its back.....At the time, the firm agreed to a cash settlement with the SEC and the State of Massachusetts that included up to $25 million in restitution to investors, pending the findings of an independent restitution consultant (internally, Putnam figured actual investor damages to be in the range of $7 million to $10 million).....Now, the consultant is about to release his findings, and it looks like the restitution will be closer to $100 million, which Putnam appears bound to accept by the terms of its settlement.....The big difference: The consultant is (properly) figuring in $53 million of transaction costs to investors, triggered by the massive withdrawals from Putnam's mutual funds following disclosure of the firm's scandalous activities.*
* "Putnam May Owe $100 Million," John Hechinger, The Wall Street Journal, February 2, 2005
Last summer (July 2004) we wrote about targeted retirement funds, and this category of funds has been getting a lot of press ever since, most of it favorable.....Recently, however, one observer took a critical eye to the Fidelity Freedom funds, which are a popular option in many 401(k) plans......Among the criticisms of the Fidelity Freedom funds:
- Too much overlap (and, we might add, too much indecision): For example, Fidelity Freedom 2020 was recently invested in 18 underlying Fidelity funds, and a number of these funds offer essentially duplicate portfolios. Fidelity should be able to identify five or ten of its top funds, and concentrate its bets on its premium offerings. As things stands now, Fidelity doesn't appear have much confidence in any of the underlying funds.
- Asset allocations are screwy, and the best funds are left out: Fidelity Freedom funds are generally light on both domestic and international small cap stocks, even those Freedom funds that are targeted at younger (and presumably more aggressive) investors. Also, some of Fido's best funds, including Contrafund, are missing entirely from its Freedom offerings.
- Too expensive: Fidelity collects a management fee for each of the underlying funds, and it also tacks on eight basis points for assembling the funds in each Freedom portfolio (most other large fund firms take only the underlying management fee). Come on, Fidelity: These are highly desirable, long-term investment dollars. Can't you be a sport, and give up that additional eight basis? And, while we're at it, how come you don't include any of your newly-cheap index funds in the Freedom lineup?
"Three Steps Needed to Bolster Fidelity's Freedom Lineup," Kunal Kapoor, morningstar.com, February 3, 2005
Even if they weren't burned by the recent mutual fund scandals, administrators of several state retirement plans are now both wiser and more wary.....Plan administrators in Maryland, for example, have put together a list of probing questions, which they've been submitting to mutual funds that do business with the state.....(You can read the questions at www.nagdca.org/resource/mutual_fund(11-03).doc).....Realistically, few individual investors could expect to receive a response to questions like these, but some of the financial advisors who read FundAlarm probably have enough clout to get some answers.....In any event, the questions highlight a number of important issues, which investors -- small or large --- shouldn't have to pry out of fund companies on their own.

"American Express had a pervasive sales culture that was established and managed with one thing in mind - to push American Express products [i.e., mutual funds]...that in many cases benefited American Express at the expense of its clients."

Those are the words of New Hampshire's top securities regulator, who's going after American Express for (1) pushing its own mediocre funds, and (2) rewarding a sales staff that followed self-serving directives from the home office.....For example, to kick off the launch of AXP European Equities in 2000, American Express held a sales contest that awarded points to AmEx advisers who sent clients to seminars that pitched the fund.....The top ten point accumulators could win a car lease, as they were informed in a company memo:*

"You have the opportunity to drive a Mercedes-Benz for one year FREE...that's right, your own 2001 Mercedes-Benz C230 sedan...Drive your client portfolio with AXP European Equities Fund."

Think about this for a moment, and consider AmEx's sleaziness and shameless betrayal: The company offered only a one-year lease, and only a C-class car!
* "American Express's Advisory Unit Faces Fraud Charges," John Hechinger/Robin Sidel, The Wall Street Journal, February 18, 2005

The NASD has charged the American Funds group with violating the NASD's "Anti-Reciprocal Rule," which prohibits (among other things) fund companies directing brokerage commissions to firms that sell the fund company's mutual fund shares.....A lot of commission dollars are involved ($100 million over three years), and the NASD appears to have documents in which American clearly spells out the "target commissions" that brokerage firms will be allocated as a reward for their prior-year's sales of American funds.....Ah, but American funds also has lawyers, and American's lawyers apparently made sure that no one at the firm "committed" to paying these quid pro quo commissions.....Without a legal commitment to pay, American contends that it wasn't in violation of the Anti-Reciprocal Rule.
Long-suffering investors in American Century Giftrust finally have a way to get out of this fund before the end of their ten-year commitment (for more recent investors, the commitment is 18 years).....Thanks to a January 1 change in Missouri state law (that's where American Century is based), fund investors may be able to break the underlying trust that has held them captive, and liberate their dying money with little effort and almost no expense.....To its credit, American Century has done a reasonably good job publicizing the new Missouri law, including a prominent mention on the American Century Web site.....When you get to the American Century Home page (americancentury.com), just look for the following Giftrust graphic:

OK, not really.....Look for the link that says "New Law Affects Giftrust," in the middle of the Home page, or you can go directly to the Giftrust Q & A (http://www.americancentury.com/trustlaw/qa.jsp).