Chapter 9: Investing in Investment Funds
**Quick update** Thanks for reading, I’ve compiled this entire series into an electronic copy that you can take offline → here
Welcome back to the Intelligent Investor series. In this chapter of The Intelligent Investor, Graham delivers his opinions on investing in investment funds. He offers insightful questions , and describes some things an investor should be weary about when it comes to buying into an investment fund. Here’s the list of preceding posts if you’d like to get caught up:
Graham opens by generalizing about Investment-Fund performance as a whole.
“On a comparative basis we would hazard the guess that the average individual who put his money exclusively in investment-fund shares in the past ten years has fared better than the average person who made his common-stock purchases directly.”
…
“We cannot help thinking, too ,that the average individual who opens a brokerage account with the idea of making conservative common-stock investments is likely to find himself beset by untoward influences in the direction of speculation and speculative losses; these temptations should be much less for the mutual-fund buyer.”
Graham sets off by giving the investor a number of questions are likely to populate when considering investment fund purchases.
- Is there any way by which the investor can assure himself of better than average results by choosing the right funds? (Subquestion: What about “performance funds”?)
- If not, how can he avoid choosing funds that will give him worse than average results?
- Can he make intelligent choices between different types of funds — e.g., balanced versus all-stock, open-end versus closed-end, load versus no-load?
We proceed with the first question and analyze Graham’s opinions on Performance Funds.
Performance Funds
In this section, Graham seeks to answer one of the first inherent questions he pointed out above. He gives examples of widespread overvaluations either intentionally malicious or by the nature of investment funds posting better than average results.
He offers that the increase in these fund prices may have come from the fact that the folks creating and running these “performance funds” had a tenure short enough to have only experienced the bull market of 1948–1968. These “performance funds” were led by large commitments in newer ventures at prices completely disproportionate to their assets or recorded earnings. The prices were only justified by :
- naive hope of the future accomplishments of these enterprises
- an apparent shrewdness in exploiting the speculative enthusiasm of the uninformed and greedy public
Graham also speaks to the impact of management tactics and ethics on the fund itself. He believes:
- The intelligent investor should be aware of some “Extraordinary Popular Delusions” brought about tactically by fund management. He’s talking about the exploitation of regulations that can cause financial statements to be deceptive in their representation.
- In the past fund management has made decisions that strictly benefit the management instead of including fund participants. Often these types of decisions even adversely affect fund participants by imposing additional fees up-front or through fund strategy.
Graham does give credit to some funds that have lasted and done only slightly better than the market over the long term (greater than 10 years). Zweig fills in here that these funds currently tend to be open-ended funds that are closed to new investors. Meaning that the managers have stopped taking in additional cash. While this reduces the management fees they can earn, it maximizes returns their existing shareholders can earn. Closing a fund to new investors is a rare and courageous step.
Closed-End versus Open-End Funds:
Graham then dives into answering the question of whether to purchase closed-end or open-end funds. Generally , he believes that:
“if you want to put your money in investment funds, buy a group of closed-end shares at a discount of , say, 10% to 15% from asset value, instead of paying a premium of about 9% above asset value for shares of an open-end company”
he adds:
if a small-load (or no-load) fund is substituted for one with the usual “8 1/2” load “, the advantage of the closed -end investment is reduced, but remains an advantage.
Essentially, by reducing your load, your “spread tolerance” gets similar to that of a closed-end fund you might have bought at discount. He adds, one should never buy a closed-end fund selling at a premium greater than 9% (charges of most mutual funds). In his experience, paying for this “premium fund” does not deliver the result that would be expected with the premium price.
Investment in Balanced Funds
Very little time is spent regarding buying into balance funds. While they are not thrown out , Graham makes a point that rather than buying into a balanced fund for the “bond component” , you’re better off purchasing United States savings bonds, Corp Bonds ≥ A or tax-free bonds for a separate bond portfolio.
Zweig’s Commentary
Zweig’s commentary is on point for this chapter. He comes in to layer a more contemporary take on what Graham offers.
When speaking about mutual funds he remarks:
Because of their imperfections, most funds underperform the market, overcharging their investors , create tax headaches , and suffer erratic swings in performance.
Zweig also makes mention of the “inborn tendency” in us all to believe that the long run can be predicted by even a short series of outcomes. This is basically because we try and find patterns in everything, even if the patterns do no actually exist. He adds that often the most lucrative sector of a given year tends to turn out to be among the worst performers the following year. When we consider this statement, we again see the need to use a mechanical system to remove the “human element” in your issue / fund decision making. As a side note, I’ve been working on building a spreadsheet that will assist with stock decisions by helping to rate certain issues based on weighted criteria. More to come on that when I finish the series.
Zweig also outlines some major advice when it comes to actually choosing an investment fund:
- the average fund does not pick stocks well enough to overcome its costs of researching and trading them;
- the higher a funds expenses, the lower its returns;
- the more frequently a fund trades its stocks, the less it tends to earn;
- highly volatile funds, which bounce up and down more than average, are likely to stay volatile;
- funds with high past returns are unlikely to remain winners for long
Some links Zweig gives to assist with fund purchase decisions and learning more about fund-investing are : InvestorHome.com and SSRN Electronic Library. Then, he advises the Intelligent Investor to look to low-cost index funds as a viable alternative to most of these “investment funds”. He states that total market index funds are typically boring, but as the years pass, the cost advantage of indexing will keep accruing relentlessly. Keeping the costs as low as possible (.1 — .2% annually versus the 2% trading costs of stock funds)on these accounts only adds to your gains since these index funds tend to outperform other investment funds in the long term.
What makes a fund beat the indexes?
Zweig continues to analyze stock funds and tries to highlight attributes of an investment fund that will outperform the market. He details the following attributes to look for in an index fund:
- Managers are the biggest shareholders
- They are cheap (higher fees = lower returns over time)
- They dare to be different (compare the holdings listed in a fund’s latest report to a roster of the S & P 500 index; if they look all the rest , find another fund)
- Their door is shut (The best funds are closed to new investors) — NOTE: Closing should happen before, not after, the fund explodes in size. Zweig gives positive accolades to the fund companies for historically being good at shutting funds on time: Longleaf, Numeric, Oakmark, T. Rowe Price, Vanguard, Wasatch.
- They don’t advertise
So, to sum up Zweig’s advice, when searching for an investment fund, follow this process:
- Check fund expenses (since a fund’s expenses are far more predictable than future risk or return, make this test your first filter)
- Analyze the riskiness of the fund (In its prospectus (or buyer’s guide), every fund must show a bar graph displaying its worst loss over a calendar quarter. If you can’t stand losing at least that much money in 3 months, find another fund)
- Analyze the management reputation — historically, did the managers make decisions that explicitly benefited fund owners?
- Analyze past fund performance
So first find a low-cost fund who’s managers are major shareholders, dare to be different, don’t hype their returns and have shown a willingness to shut it down before they get too big for their britches. Then, and only then, consult their Morningstar rating.
Something to remember about past performance is that past performance is only a pale predictor of future returns. One thing is certain though, yesterday’s winners become tomorrow’s losers, but yesterday’s losers almost never become tomorrow’s winners. So avoid funds with consistently poor past returns, especially if they have above-average annual expenses.
Knowing when to sell out of a fund
If you’ve bought into a fund, you will need to determine when and what attributes might signal you to sell and take your winnings into a safer direction. Zweig offers the following “red-flags that mean it’s time to sell”:
- A sharp and unexpected change in strategy by the fund managers
- An increase in expenses
- Large and frequent tax bills (generated by excessive trading)
- Suddenly erratic returns (in both directions)
Zweig does mention that modern ETFs may also offer a good alternative to investment funds. While many of his instructions apply to ETFs as they might the investment funds, he does point out that they may not be suitable for investors who wish to add money regularly, since most brokers will charge a separate commission on every new investment.
Although a bit of an unexpected chapter, given it deals with investment funds instead of the general stock-picking and analysis side of equity markets that I’ve come to be more familiar in this book, this chapter does a good job of explaining an alternative investment that the enterprising investor can leverage in his portfolio. Zweig ends with a comment that applies to all of these discussions but is even more pertinent to fund investment: “Patience is the fund investor’s single most powerful ally.”
As I continue to work through the chapters, my goal is to post on each chapter’s central tenets. If you find something out of place, or care to strike up a discussion feel free to comment or find me on twitter @DavidCappelucci.
Recommend the article if you found value in it and would like to follow along.
-David
