http://funds-newsletter.com
Copyright 2013 Tom Madell, PhD, Publisher
Feb. 2013

Contents:

-Managed Funds: Are You Getting What You Have Paid For?
-Funds That Will Wind Up Outperforming Can Often Be Identified in Advance

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Managed Funds: Are You Getting What You Have Paid For?

By Tom Madell

When you invest in a managed fund, as opposed to an index fund, you are acquiring the services of one or more presumed investment professionals who analyze and select which particular individual investments will be included in the fund's portfolio. With an index fund, the investments are merely a large sample, or perhaps all, of the investments that make up a pre-defined set. Since a managed fund requires more effort to run than an index fund, you will incur a greater expense in the choice of the former.

However, the argument rages that since managed funds have only a very mediocre record in doing better than index funds, that perhaps investors should forget the former and only invest in low-cost index funds and/or ETFs. Those investors who do invest in managed funds are expressing the hope that the skill of the manager(s) will enable them to do better than an unmanaged index.

I recently came across several articles that called my attention to an idea I was unfamiliar with: Sometimes, managed funds are so constructed as to vary very little from the index they are designed to compete against. If so, the thought goes, an investor in such funds is likely overpaying for them since they have little chance of beating the nearly identical index and will usually trail the index when the manager's fees deducted from the actual portfolio's pre-fee returns.

You may wish to check out these articles yourself:

"How to Find a Fund Manager Who Can Beat the Market"

"Stock Market Correlation Leads to 'Closet' Indexing" (Note: You may need to register there for free.)

Here are a few of the most important points from each.

From the first article:

-"Only 10% of the 1,991 U.S. stock funds that investment-research firm Morningstar tracks beat their benchmark in both 2011 and 2012."

-"Last year, if an investor randomly picked a fund with an expense ratio of 0.86% or less ... he would have had a 45% chance of beating the index, according to Morningstar, instead of the 35% chance if he had picked any fund. Funds with expenses below 0.75% had about a 50% chance.

-Look for a statistic called "R-squared" on the "Ratings and Risk" tab of a fund on morningstar.com. The closer the number is to 100, the more exactly the fund's return corresponds to the index's return; the average for funds turns out to be 93% which shows they hew closely to the index. "...[F]or every 10% reduction in R-squared, an investor improves his performance by 0.8 percentage point, after adjusting for size, style and other factors..."

From the second article:

-"[T]he steady rise in correlations among stocks across the board is making it more difficult than ever for actively managed funds to differentiate themselves from their benchmarks. ... the 10 largest actively managed stocks fund in the world ... now have an average three-year R-squared of 97, up from 83 in 2007, Morningstar said. ... Believe it or not, those 10 funds are doing better than their peers. The average large-cap-blend fund has an R-squared of 99.7." Note: Funds with such high correlations are derogatively referred to as "closet index" funds.

-Thus, it becomes apparent that investors in most large cap funds are getting essentially the performance of the index, minus the fees paid. In other words, they are not getting their money's worth compared to merely investing in a fund that mirrors the index with usually much lower fees.

-One potential benefit of managed funds over index funds is if the manager is skilled enough, he/she can shift to some defensive investments, including cash, if and when we enter a bear market. An index fund must remain fully invested.

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Funds That Will Wind Up Outperforming Can Often Be Identified in Advance

By Tom Madell

Since the inception of my Newsletter's Model Portfolios in 2000, it has been my goal to help readers select what I expect to be solid fund choices. However, the funds I recommend are not likely to be those that will wind up at the top of the heap or those that will enable you to achieve a huge profit over a short period of time. Rather, I make the assumption that most readers want funds that they can hold without taking on huge risks. This means that while one may not do as well on occasion as when investing in the "hottest" of funds, one does not have to worry that their choices may turn out to be merely "one-time wonders."

While many investors undoubtedly focus on my current choices of funds (see the Jan. 2013 Newsletter), it is important too to take a historical perspective. This can be accomplished by comparing our present recommendations to those we made in the past. What you will discover is that while we may occasionally introduce some totally new choices in our Model Portfolios, including ETFs, many of the funds we recommended years ago are among the funds we still recommend today. By and large, most, but certainly not all, of these prior choices have indeed lived up to our expectations and performed well, as you may know if you are a long-time subscriber.

In the discussion and tables below, I think you can get some additional insights into why it pays to be a long-term investor and how it is indeed possible to find good funds that will do well as compared to benchmark indexes such as the S&P 500 and the comparable index for bond funds.

Funds from One Year Ago (Jan. 2012)

Also in the Jan. 2013 Newsletter, I presented performance data on all the funds in our Jan. 2012 Model Portfolio. Twelve stock funds were listed in 7 different fund categories; however, if one selects just the single fund in each category that we had featured many times before, you will find that our choices, when weighted as we recommended at the time, returned 17.6% over the entire calendar year. This compares to a return of 16% for the S&P 500 index.

The group included FLPSX, VWIGX, VFINX, VIGRX, VWNFX, VGSIX, and VEIPX (see the above link for the corresponding fund names). We continue to like all these funds.

We likewise presented 12 bond funds, also in 7 different fund categories. Once again, if you select just the single fund in each category that we had featured many times before, the resulting one-year performance turned out to be outstanding. When weighted as we recommended at the time, the Bond Portfolio returned an annualized 9.2% vs. a return of 4.2% on the most widely used bond fund benchmark, the iShares Core Total US Bond Market ETF (AGG). (Note: we use the after-tax equivalent return for investors in the 28% Federal income tax bracket when computing muni bond fund returns.)

These funds included PTTRX, PRRIX, VFIIX, VWITX, VWESX, VWEHX, RPIBX (refer to the above link for the corresponding fund names). The only one of these funds we don't still recommend is RPIBX. Rather, we now prefer PIMCO Foreign Bond (Hedged) Adm (PFRAX).

Our total recommended Jan. '12 portfolio allocation to stock funds for Moderate Risk investors was 62.5%; for bond funds, 32.5%. The rest was in cash. (Note: Our allocation to stocks is always higher for Aggressive Risk investors but less for Conservative Risk investors.)

Funds from Three Years Ago (Jan. 2010)

Three years ago this January, my Model Stock Portfolio consisted of just the 7 funds shown below. The last column shows the 3 year annualized performance through Dec. 31, 2012.

Jan. '10
Recommended Fund

Recommended % of
Stock Portfolio

Category

Annualized Long-Term
Performance

Vanguard Growth Idx (VIGRX)

30%

Large Growth

11.6%

Vanguard Internat. Gr. (VWIGX)

25

International Large Blend

6.2

Vang. Large-Cap Idx (VLACX)

22.5

Large Blend

10.8

Vang. Mid-Cap Growth (VMGRX)

7.5

Mid-Cap Growth

12.9

T. Rowe Price Value (TRVLX)

5

Large Value

10.7

Vanguard Small Cap
Growth Index (VISGX)

5

Small Cap
Growth

14.8

Vanguard Small Cap Index (NAESX)

5

Small Blend

13.6

Note: Performance shown does not include this January's over 5% gains for many stock funds; the above funds are in most instances doing even better, adding approximately 2% annualized to the performance shown above.

The Stock Portfolio, when weighted as we recommended in Jan. 2010, returned 10.4% annualized over the 3 year period. This compares to a return of 10.9% for the S&P 500 index. Of course, our portfolio was more diversified than the S&P 500 with our International fund accounting for all of the short fall; also, the S&P index itself is not available to investors, only funds or ETFs which having varying expenses.

The Model Bond Portfolio from 3 years ago also consisted of 7 funds. (Note: There were also 2 Harbor Bond funds but these funds are practically identical to their corresponding PIMCO funds except that the expense ratios are higher but have a lower initial investment.) The 7 funds, when weighted as I recommended in Jan. 2010, returned an annualized 7.3% over the 3 year period. This compares to a return of 6.2% for the bond benchmark index (AGG). The table below shows the funds. The last column shows the annualized 3 year performance through Dec. 31, 2012.

Jan. '10
Recommended Fund

Recommended % of
Bond Portfolio

Category

Annualized Long-Term
Performance

Vanguard Tot. Bond Market (VBMFX)

12.5%

Interm Term Govt

6.0%

PIMCO Total Return Instit (PTTRX)

40

Diversified

7.8

Vang. Interm. Term Tax-Exempt (VWITX)

15

Interm Term Muni

8.1

PIMCO Real Return Instit (PRRIX)

7.5

Inflation

9.5

T. Rowe Price Intl. Bond (RPIBX)

10

International

4.6

Vang. Sh-Tm Investment Gr. (VFSTX)

10

Short-Term Non-Govt

3.9

Vang. High Yield (VWEHX)

5

High Yield

11.3

Our total recommended Jan. '10 portfolio allocation for Moderate Risk investors was 57.5% to stock funds and 37.5% for bond funds. The rest was in cash.

Funds from Five Years Ago (Jan. 2008)

Five years ago this January, my Model Stock Portfolio consisted of 12 funds from 7 different categories. However, I show only the single fund from each category that we most often recommended in prior Newsletters up to that point. The last column shows each's annualized 5 year performance through Dec. 31, 2012.

Jan. '08
Recommended Fund

Recommended % of
Stock Portfolio

Category

Annualized Long-Term
Performance

Vanguard Growth Idx (VIGRX)

22.5%

Large Growth

3.2%

Vanguard 500 Idx (VFINX)

22.5

Large Blend

1.6

Vanguard Mid Cap Growth Idx (VMGRX)

7.5

Mid Cap Growth

3.8

MainStay ICAP Equity (ICAEX)

10

Large Value

1.3

Vanguard Intl Growth (VWIGX)

20

Foreign Large Blend

- 1.4

American Cent. Intl Growth (TWIEX)

7.5

Foreign Large Growth

- 2.2

Fidelity Pacific Basin (FPBFX)

10

Diversified Pacific/Asia

- 1.4

The Stock Portfolio, when weighted as we recommended in Jan. 2008, returned 0.9% annualized over the 5 year period. This compares to a return of 1.7% for the S&P 500 index. Once again, the shortfall was entirely due to our 3 international picks. But diversification suggests that all but the most conservative of investors should maintain an international position.

The Model Bond Portfolio from 5 years ago consisted of 5 funds shown below. The bond portfolio, when weighted as I recommended in Jan. 2008, returned an annualized 6.6% over the 5 year period. This compares to a return of 5.9% for the bond benchmark index (AGG). The last column shows each's 5 year performance through Dec. 31, 2012.

Jan. '08
Recommended Fund

Recommended % of
Bond Portfolio

Category

Annualized Long-Term
Performance

Vang. Sh Tm Treasury (VFISX)

20%

Short Term Govt

2.7%

T. Rowe Price Intl Bd (RPIBX)

10

International

4.8

PIMCO Total Return Inst. (PTTRX

35

Intermediate Term

8.4

Vanguard LT Tax-Exempt (VWLTX)

25

Long Term Muni

7.9

Vanguard Infl Protected (VIPSX)

10

Inflation

6.7

Our total recommended Jan. '08 portfolio allocation for Moderate Risk investors was 52.5% in stock funds, 30% in bond funds, and 17.5% in cash.

Funds from Ten Years Ago (Jan. 2003)

Normally, we wouldn't expect recommendations made any further than 5 years ago to still be useful to investors. That is because so much can change over such a long period as to render such judgments on funds hardly worth considering.

For example, one of the 6 funds we recommended 10 years ago no longer exists as such, and was merged into a series of other funds. Another went from being a great fund with a great long-term manager to a relatively poor fund with a revolving door of managers, the Fidelity Growth and Income Fund.

However, the 4 remaining funds would have turned out to be great picks. Here the funds are with their 10 yr. annualized return. (Compare returns to the 10 yr. annualized return of 7.1% for the S&P index.)

All 4 of our 2003 bond fund picks, if held over 10 years, did better than the annualized bond benchmark of 5.2%

At the time, our overall allocations were 50% to stock funds, 50% to bond funds, and 0% to cash.

To Recap: Good Funds Can Usually Be Identified In Advance

While most stock funds held over the last 5 years have barely been positive through Dec. 2012, ten year returns have actually been quite good. And being well diversified between stocks and bond funds and many fund categories certainly paid off during the 5 year period that stocks did relatively badly.

I believe the above data justifies the following conclusion: When one has access to information which allows him/her to usually be able to identify so many excellent funds in advance of their subsequent performance, one should feel assured there is less reason to constantly worry about market conditions, or what funds' are "hot" and those that are not. You should note though that, for the most part, such excellent returns are typically served up only to those willing to hold these funds for long periods.

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