Hacker Finances: Stocks Versus Mutual Funds, Part I
As a stock picker, I’ve made every mistake in the book. As a mutual fund picker I’ve made, maybe, two. It’s not for lack of trying, mind you. I’ve spent a lot more time studying individual stocks and learning what differentiates a good one from a bad one than I have spent finding good mutual funds. But I’ve lost as much as 101% on stocks that I’ve invested in, and I’ve never sold a mutual fund at a loss at all. The reason I’ve done better with mutual funds is that they are inherently safer than individual stock investing. Mutual funds are simply baskets of stocks that are chosen by professional fund managers and their teams. The stocks they buy are chosen to meet the fund’s objectives, which can be broad based like ‘growth’ or ‘international’. Or they can be focused like ‘medical equipment’ or ‘banking’. Over long periods, mutual funds are basically foolproof.
Mutual funds are probably the best choice for investors who want a low-maintenance investment that they can check in on periodically and which they don’t expect to liquidate for quite a few years, but still be assured of a good return. And mutual funds should be the foundation of most Hacker investment portfolios. Over ten years or more, well managed mutual funds will generally perform as well or slightly better than the overall market. Three that I am holding today include Fidelity Contrafund, Fidelity Medical Equipment Select Fund and Hennessey Focus Fund. All three have performed better, over the last 25 years, than any of the major US indexes, which include the Dow Jones Industrials, S&P 500, and the NASDAQ. Pop quiz: If you heeded my first post in this series, ‘Hacker Finances: Introduction’, then you know whether those 3 indices are up or down today.
There are a couple of important factors to keep in mind before looking at mutual funds as an investment. These factors are both related to the way mutual funds distribute cash. When a fund is operating, it generates cash. The cash comes from selling stock positions, and, from dividends that are paid by the individual stocks the mutual fund holds. Most funds will make a cash distribution one or more times per year. The amount distributed varies from year to year and depends on the details of the fund’s operation over that year. For example, on December 9th, 2015, the Hennessey Focus Fund, HFCSX, made a distribution of 0.2% of its net asset value. In making the distribution, investors who elected to have the distributions reinvested saw a few shares of HFCSX added to their account, and the net asset value adjusted down by 0.2%. Those who did not elect to reinvest just saw 0.2% of the fund balance drop into their cash account, and their fund balance drop by the same amount.
When you invest in a fund, you’ll typically be able to choose whether to have the distributions reinvested. If you choose reinvestment, your broker will automatically use the cash from the distribution to purchase more shares at the fund price on the day of distribution and add the new shares to your account.
This makes comparing mutual fund performance tricky. Here’s an example of why: Let’s take a look at a 10 year chart for Barons Growth Fund, BGRFX, from Yahoo! Finance:
The chart shows that over 10 years, the net asset value (NAV, or share price) increased 45.9% from $45.22 to $65.98.
However, here is BGRFX over the same time period as presented by Morningstar:
This chart shows the value of a $10,000.00 investment growing to $20,080.90 over the same time period. That is just over 100% in the same 10 year stretch for the same fund. The difference is that in the Yahoo! chart, the distributions are not re-invested. You can see them flagged as ‘D’ in the time line and if you pull up the chart and hover over the ‘D’, you’ll see the distribution amount per share. In the Morningstar chart, the distributions are reinvested.
I used to get a call from my dad once in a while wherein he’d gloat about my poor choice of mutual funds compared to his superior choices in stocks. He’d point out that my mutual fund had dropped 5% on the same day the market had rallied, and how incompetent is that? So I’d have to explain to him, again, that my fund had just paid a 5% capital gain and dividend distribution, and that while the NAV price did drop 5%, I also got 5% more shares and the value was a wash. Neener, neener.
So when you are shopping for a mutual fund, be careful to pay attention to the data you are comparing and be sure it represents the reinvestments as part of the data. Otherwise, you’ll believe they are performing much worse than they are. For BGRFX, it is a difference of a 45.9% return versus 100.8% over 10 years.
There is one more factor related to mutual fund distributions. If you hold the fund outside of a retirement account, the distributions are taxable. Each year, you’ll get a 1099 form from your broker that lists out the short term capital gains, long term capital gains and dividends that the fund distributed in the prior tax year. Each of those has a different tax rate, and you’ll have to pay the income taxes on the distributions, even if you’re reinvesting them. If you don’t have the cash to pay the taxes, simply sell enough shares to cover the tax. The tax obligation will be a small percentage of the position.
When looking for a mutual fund, there are a few fairly straightforward things to look for. These include A) the size of the fund, B) past performance compared to the overall stock markets, C) the investment goals of the fund, D) the tenure of the fund manager and E) the expense ratio. It’s worth some discussion regarding each of those aspects. No pop quiz on this, but it’s more or less everything you’ll need to know about mutual funds.
A) The size of the fund matters because the bigger the fund is, the more limited their investment choices become. Their choices of which stocks to buy become limited because if they buy shares in a small company, the absolute dollar investment can have a large effect on the share price of the small company and push the share valuation out of whack. So they have to buy large-cap companies. If you take a look at the top 10 holdings for FCNTX, a ‘Large’ fund with total holdings of $106 Billion, they are among the largest-cap companies:
However, Contrafund’s ownership in each is relatively small, around 2%. Note that small funds can still hold positions in large cap stocks. But large funds generally can’t invest in small-cap companies. Personally, I don’t like the fact that a fund’s choices are limited, so I prefer small and medium sized funds. At least, I did until my dad pointed out that if a fund manager is good, their fund will get big.
Let’s take a look at a fund that has an investment goal of small-cap stocks. This is Neuberger Berman Genesis Fund, with a total value of about $10 Billion, 1/10th the size of Contrafund:
This fund has an average holding of about 4% of the companies that it invests in, and they are all small cap stocks. What matters, from my layman’s perspective, is that smaller companies have more upside potential than large companies. Hence, a mutual fund with an investment goal of small-cap stocks should have more upside than a mutual fund with an investment goal of large cap stocks. It turns out that my layman’s perspective is what you might expect from a layman: Wrong. Here is a chart showing FCNTX versus NBGNX since 1991:
So, yes, over 25 years, the small-caps did a little better than the large caps. But it was touch & go. Large caps did better through most of the 90s. Then, from about 1999 to 2002, small caps out performed pretty dramatically. Since 2002, small cap and large cap tracked almost even. The period that small caps did better was the height of the Internet bubble and subsequent burst. This was a unique period in the stock markets, and so the small cap performance during that period may not be a standard cyclic behavior. At least it doesn’t appear to be over that 25 year span.
C) Size is one attribute, another is industry focus. There are mutual funds that have investment goals for myriad industries and nations. For example, I’ve owned mutual funds focused on such diverse industries as medical equipment, chemicals and brokerages. B) The brokerages was one of my mutual fund failures. I still sold it for a profit, but the return was far less than most other mutual funds. I managed to buy it in 2006, just before the housing bubble financial crisis, and sold it in 2015:
After the meltdown in 2008, it took 6 years for the NAV to return to what I paid for it. I managed a 39% gain in 8 years, which is a paltry 4% annualized. Over that same period, FCNTX more than doubled, returning 8.6%.
D) When analyzing mutual funds, look for funds that have had the same captain for at least 10 years. Fund managers are like CEOs and you want one who has demonstrated superior performance. Fund managers that are new to a fund may be just fine, but you don’t know that until you’ve seen how they do through different economic cycles. One pretty obvious example of how this can matter is the Magellen Fund. From 1977 to 1990, the Fidelity Magellan fund was run by Peter Lynch. If there are rock stars in the investing world, Peter Lynch is one of them. Over that 13 year stretch, Magellan grew almost 30 fold. That represented an annualized growth of 29%. Over the 13 years after he moved on, Magellan was run by 3 different fund managers, who managed 18%, even if you allow them to stop at the peak of the Internet bubble in 2000. They barely beat the S&P 500. A dart-throwing monkey would have done as well [1].
E) Whether they are masters or monkeys, all those fund managers and their teams don’t come cheap. You have to pay them. You pay them through fees that they take along the way as they manage your investment. Typical management fees are around 0.5% — 1.5% annually, and most funds also charge a sales fee, although some of the larger brokerages, like Schwab and Fidelity, have what are called no-load funds. No-load means no sales fees are charged. Many financial advisers make a big deal out of management fees, sales fees and the expense ratio. Pay attention to it, but also take a look to see if a high expense ratio may be justified by superior performance of the fund. Just like a good CEO, a good fund manager is worth paying more for.
The last thing I’ll say about mutual funds is that they are rated by a variety of firms. The best known mutual fund rating agency is Morningstar. Morningstar uses a variety of metrics to gauge the quality of a fund. Typically, the rating is a combination of the performance vis-à-vis the attributes we’ve discussed here. If you’re searching for funds to invest in, it’s worthwhile to limit the search to funds with 5-star Morningstar ratings. Another opinion is valuable when putting your money to work.
To get started with mutual funds, take a look at a fund screening tool. I typically use Fidelity’s at https://www.fidelity.com/fund-screener/research.shtml . Select US Equity as an asset class, if you are in the US. That way, the individual stocks they hold are more likely to be familiar to you. If you’ve got a horizon of, say, 15 years or more, select the Large Growth category. De-select ‘No Transaction Fee’. You should see something around 600 funds. At this writing, the best performing Large Growth Fund over the last 10 years is Shelton Capital Management (NASDX). They’ve returned 11.9% annualized over the last 10 years. That’s really healthy.
Over the last 10 years, NASDX has crushed both its large-cap peers and the S&P 500, returning ~300% versus their ~200%.
Select NASDX, and take a look at some of the details. The top 10 holdings are the large tech companies we know and many of us work at: Apple, Microsoft, Amazon, Facebook, Google. The fund manager is Stephen Rogers, who has been at the helm since 2003, so the 10 year, 11.9% performance was under his watch. There are fees, but again, this is the best performing over the last 10 years and most likely, the performance is worth paying for.
Investing in individual stocks is another matter entirely. Nothing feels worse than realizing you missed one. I don’t mean, you come across a stock that you’d never heard of that returned 61% annually for 5 years. Like Nautilus (NLS). I mean, nothing is worse than that feeling you get when you realize you missed one that was a product or service you use and love. We’ll talk about analyzing and picking stocks in Stocks Versus Mutual Funds Part II.
[1] “The Surprising Alpha From Malkiel’s Monkey And Upside-Down Strategies”: http://bit.ly/1bcOAh3
