Copyright 2021 Tom Madell, PhD, Publisher
Feb. 2021. Published Jan. 27, 2021.
In the Jan. 2021 Newsletter, I took a look back at how outstandingly well some of my previous Newsletter's recommendations did in subsequent years. In this article, I will look ahead to how each of the most popular stock fund categories, and some newly recommended funds in these categories, may do over the next several years.
Obviously, it should be apparent that it is impossible for anyone to predict with any degree of certainty how such categories, and specific funds within them, will do. However, I will once again attempt, as I did in the Jan. 2016 Newsletter and as reported on in the Jan. 2021 Newsletter, to estimate the relative performance prospects of fund categories, and additionally include some particular funds within those categories that I feel should have a good chance of producing excellent results.
I have already presented my own personal list of "Recommended Funds," most recently in the Dec. 2020 Newsletter. But for those who might not have access to these funds or prefer to see some more options, I am going to present some alternate, non-index funds that might now also be given consideration. While I still find my original Recommended Funds among the best choices available, these alternate funds were selected through an extensive search aimed at identifying only those funds potentially having a relatively rare combination of above average, attractive qualities for long-term investors seeking to start out with some new fund choices. Exclusively managed funds were chosen because most popular index funds are nearly identical to each other and it is not difficult to find and merely pick out a low cost fund within a desired category.
How were these alternate funds selected? Below, I show the six criteria I used and the rationale for using each. Each of the first five criteria can be measured objectively and are not a matter of mere opinion, and, most experts agree, are related to successful fund performance. The sixth was a more optional choice and ensures that new investors can still get in.
I decided to select these alternate funds only if they met each and every one of my six criteria, or, only in a few cases, just missed the mark on one by a small amount. Surprisingly, finding such funds became almost like finding a needle in a haystack. Only a tiny minority of funds were able to emerge because the great majority of funds wound up missing at least one, and perhaps many, of these criteria. In other words, when applying all these criteria to any given fund, it became quite difficult to arrive at this highly selective set of funds, one fund for each of a little more than a dozen categories. Due to the rigorousness of my selection process, the funds identified, therefore, should have an outstanding chance of performing well in upcoming years.
1) Expense ratio no higher than 1.00%.. The expense ratio comes directly out of what a fund's stock or bond portfolio is able to earn. That's why a low cost index fund starts out with a big advantage over a managed fund. That's one reason 9 out of 13 of my most successful stock fund choices, that is, my original aforementioned Recommended Funds, have turned out to be index funds.
While funds with higher expense ratios can also turn out to be wildly successful, the higher the expense, the lower the probability you will do as well as you might otherwise. One of the main reasons index funds tend to do better than managed funds is not only because of lower cost, but also because trying to pick individual securities to beat an index is extremely difficult. Unless a fund manager can successfully do that, and, in reality, relatively few actually can, he/she will always trail an index because of the added cost that is reflected in high expense ratios.
Does this mean that an investor should never choose a managed, non-index fund? No, because if you can identify such a successful managed fund, you may be able to achieve returns at times far in excess of that achieved by an index fund. There are many examples, but one should still recognize that such index-beating returns are almost always in the minority.
As an example, consider one of my most successful managed Recommended Funds, Vanguard International Growth Adm (VWILX). Out of the last 10 years, it has beaten the Vanguard Total International Stock Index Admiral (VTIAX), its most comparable index, during 8 of those years. Over the period, a 10k investment in the index fund would have grown to $16,488, while in the managed fund, to $32,170, or nearly double. This is in spite of having a higher expense ratio than the latter, 0.33% vs. 0.11%. But it should be noted that VWILX invests mainly in Growth stocks while VTIAX invests much more across the board.
2) Funds that are in the upper half against their category competition over the last 5 years. While many funds may have done well on an absolute basis, we also need to see if they have done well relative to other funds in their category. For example, while an average annual return of 15% over the last 5 years may seem highly appealing, the majority of funds in its category may have exceeded that performance. That makes such a fund seem less attractive. Perhaps the fund is in a category such as Large Growth that literally shot out the lights over the last 5 years. In that case, a 15% annualized return may put it closer to the bottom of the pack as compared to how other similar funds have done.
One can easily check where a fund stands performance-wise against its category competition by clicking on the Performance menu item on its Morningstar.com web page. Under Trailing Returns, look for the Percentile Rank number shown in the 5-Year column. Any number 50 or below indicates the funds is in the top half of its category; the lower the number, the better it has performed against its fund category peers.
3) Have a yearly portfolio turnover of 40% or less. Turnover measures how frequently the stocks in the fund are sold in a given year. A turnover of 100% would mean that the fund manager has theoretically replaced every single stock within a year's time.
Turnover can range from 0 to hundreds of percent if the manager is doing an extreme amount of trading. The average turnover for actively managed funds is somewhere around 60%. On the other hand, the same rate for index funds or unmanaged ETFs is about 5%, reflecting that new stocks may be added to the index, or some dropped from it.
Research has shown that a high turnover rate is frequently associated with lower returns; see this article for an excellent brief discussion of this.
There are probably several reasons for this. First, the more trading a fund does, the more expenses it racks up because trading involves transaction costs. So excessive turnover goes hand in hand with high expense ratios. Second, if the fund is held in a taxable account, trading can lead to higher capital gains distributions to investors if the trades are showing a profit. Finally, even the brightest fund managers often buy and sell stocks at the wrong time, leading to lower returns than just holding a portfolio steady. That, along with extremely low expense ratios is one reason why index funds outperform managed funds the majority of the time.
Of course, my selection of above 40% turnover as one criterion for eliminating a mutual fund is completely arbitrary. The percent might easily be set lower or somewhat higher. However, you will find that most actively managed funds fail to meet this criterion. In the competitive business of mutual funds, perhaps most fund managers continue to strive for superior returns by trading in and out of stocks. Some may be overconfident in their ability to successfully trade and may not take into account that excessive trading often leads to poorer returns rather than better ones.
4) Have at least one manager who has been with fund for at least 5 years. In the January 2021 Newsletter, I showed how long tenured managers who have done well over a number of years are often your best bet when selecting funds.
When considering good five year performance of a fund, as in criterion 2) above, one should probably disregard that performance if a previously departed manager was at the helm for most of that period. In such a case, that departed manager may be the one who achieved most of the good result, not the current manager who may have been on board for perhaps just a year or two.
Managers who earn good returns over a number of years are certainly less likely to be replaced or leave because of dissatisfaction than managers who are shown the door or choose to leave when they don't perform well. And investors are likely to reap the benefit of such a long tenured manager's experience.
5) Only funds adhering to their stated category. A fund may represent itself to investors as investing in a certain category, such as Large Growth or Small Value. Investors may choose to invest in such a fund based on that description. However, an examination of the type of stocks actually in the fund's portfolio may reveal that it has strayed from that description. Thus, for example, the Large Growth fund may currently have more stocks that are actually Large Blend in nature than Large Growth. Likewise, the supposedly Small Value fund may actually have more stocks that are classified as Mid Value.
Why is this a problem? It may not be a problem for an investor who has only a very small number of funds. In fact, for diversification, almost all funds are made up of stocks drawn from a variety of categories. This helps ensure that the fund likely won't perform terribly if its main category does very poorly during a particular period. So an investor who does not have another fund that gives exposure to the "added on" category may be helped by achieving better diversification.
Such "style" or portfolio "drift" may also actually help the investor if the fund's category has been doing poorly and the manager shifts stocks away from that category into another category that has been doing better.
But many investors already have investments in a variety of categories. If the fund manager has tilted a significant proportion of stocks away from what the investor might have purchased the fund for, the investor's portfolio may now no longer be allocated the way he/she intends. As a result, you may have more invested in a given category than you had planned. Further, it should be recognized that such drifts are actually a form of market timing by the fund manager. As we are usually warned, market timing is more often than not associated with an investor earning poorer returns than better ones.
If you wish to try to avoid investing in a fund that has drifted too much away from its stated category, you can go to Morningstar.com and click on the "Portfolio" menu item for a given fund. On the right side, you will now see a graphic representation under "Stock Style." Now click on "Weight." This allows you to see the current percentages of the fund portfolio invested in each of the nine investment categories tracked by Morningstar. The fund's stated category is shown just to the left at the bottom of the "Asset Allocation" table. If any of the percentages shown in the graphic is more than the percentage for the stated category, the fund has drifted and you may not be getting what you expected when you selected the fund.
6) Funds that have done as well as my Recommended Funds within their category, are open to new investors, and require no more than 5K to open. As previously stated, my Recommended Funds are shown in the Dec. '20 Newsletter. To make such a performance comparison, I used 5 year returns as of Jan. 22, 2021. And, as it turned out, a very high minimum opening investment or a fund closed to new investors eliminated many otherwise suitable funds.
Note: Given the thousands of funds available to investors, screening for these criteria becomes a laborious chore. I found that using a so-called fund screener can help one to locate funds that meet some of these or other criteria. In particular, I found the following two online screeners helpful:
The following two tables present nine basic domestic stock fund categories and five international stock categories. In each table, the categories are listed in order from those I expect to do best at the top of a table to those that I project will likely do less well at the bottom. All of the categories are considered "Holds.", although the three domestic Growth categories have been downgraded due to excessive valuation concerns. The ranking of categories is based on previous research described in earlier Newsletters. The table reflects performance prospects as determined in late January.
|Fund Category||Alternate Funds|
|Large Blend||Parnassus Core Equity Investor (PRBLX)|
|Mid-Cap Blend||Fidelity Mid-Cap Stock (FMCSX)|
|Small Value||DFA US Targeted Value I (DFFVX)|
|Small Blend||Royce Pennsylvania Mutual Invmt (PENNX)|
|Large Value||Dodge & Cox Stock (DODGX)|
|Mid-Cap Value||Fidelity Low-Priced Stock (FLPSX)|
|Large Growth||Laudus US Large Cap Growth (LGILX)|
|Small Growth||Ivy Small Cap Growth I (IYSIX)|
|Mid-Cap Growth||Janus Henderson Enterprise D (JANEX)|
|Fund Category||Alternate Funds|
|Diversified Pacific/Asia||Matthews Asia Dividend Investor (MAPIX)|
|Emerging Markets||Voya Emerging Markets Index Port I (IEPIX)|
|Japan||T. Rowe Price Japan (PRJPX)|
|Europe||DFA Continental Small Company I (DFCSX)|
|Diversified International||None (see Note below)|
In the March Newsletter, I will discuss the current bond funds categories with the best prospects, along with alternate fund selections to my Recommended Funds.
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