GETTING GOING

By JONATHAN CLEMENTS

 

Why Otherwise Good Investors Cling To Mutual Funds with Lousy Records

 

August 17, 2005

The numbers don't lie. But some mutual-fund investors are having a hard time facing the truth. At issue are the billions of dollars residing in huge stock funds with wretched records. How bad is the problem? Consider this: There are 126 stock funds with $1 billion or more in assets that have lagged behind their category average over the 10-year period through July 31, according to Chicago fund researcher Morningstar Inc. These 126 funds collectively manage $438 billion, equal to 9% of all money invested in stock funds. Sure, patience is a virtue, but at what cost? Losing big. As a longtime fan of index funds, I fully expect actively managed funds to underperform market averages like the Standard & Poor's 500-stock index. Over a 10-year stretch, between 60% and 90% of U.S. stock funds in any one category will typically fall behind their category's benchmark index. Our 126 behemoths, however, have suffered an even more ignoble fate. They have fared worse than most funds in their category. These funds are run by some of the country's best-known fund companies, including AIM Investments, Alliance Capital, Dreyfus Corp., Fidelity Investments, Franklin Templeton, Janus Capital Group, MFS Investment Management, Morgan Stanley, OppenheimerFunds, T. Rowe Price Group, Putnam Investments and Vanguard Group. Included in the 126 are some balanced

funds, which own both stocks and bonds, and even some index funds.

 

Sound grim? It gets worse. Among our laggards are 48  funds that have also

trailed their category average over three and five years. These funds have lately given shareholders little reason for hope -- and yet they collectively manage $192 billion. The three-strikes camp includes today's poster child for underperformance, Fidelity Magellan.

 

Magellan has fallen behind the S&P 500 in seven of the past 10 years, but it continues to boast $55 billion in assets. Weighing in. Arguably, Magellan is so big that no manager, no matter how talented, could generate stellar long-run results.

But that isn't true for most of the other laggards. True, a big asset base can be a disadvantage, partly because it's tougher to trade in and out of stocks, and partly because managers have so much to invest that they can no longer stick with just their best investment ideas. Still, $1 billion isn't a huge amount to be managing, especially with the U.S. stock market now valued at more than $15 trillion, as measured by the Dow Jones Wilshire 5000 "total stock market" index. "It would be insane to own a micro-cap fund with a $1 billion in assets," says Minneapolis financial planner Ross Levin. "But I wouldn't think twice about buying a large-cap fund with $1 billion in assets."

In fact, funds that outpace their category average tend to have more in assets than those that underperform. That is no great surprise: Investors flock to funds with good performance. What is surprising is the patience of investors in large funds with dreadful results. Yes, some funds will inevitably be below average. But why stick with them?

Taxing matters. One possible explanation is shareholders may be reluctant to cash out because they don't want to pay the resulting tax bill.

But I am not buying this argument. For starters, according to Washington's Investment Company Institute, almost 40% of mutual-fund assets are in tax-sheltered retirement accounts. Meanwhile, even if shareholders held these laggard funds in their taxable account, they probably wouldn't pay a big tax price for selling. Once they figure in the fund income and capital-gains distributions that they have received over the years and reinvested in additional fund shares, these investors may find their cost basis for tax purposes is surprisingly high -- and the unrealized gain is fairly modest.

Trading up. To understand why these shareholders don't sell, I think we need to look to investor psychology. That brings me to a new study by Woodrow Johnson, a finance professor at the University of Oregon. According to his study, if a fund performs poorly, new investors stay away and existing shareholders don't add to their holdings.

Poor performance, however, doesn't prompt existing shareholders to rush to sell. "My guess is that most investors are unsophisticated and they are going to hang on until they need the cash or they meet their goal," Prof. Johnson says.

Meir Statman, a finance professor at Santa Clara University in California, suspects this tenacity is driven by our reluctance to sell bad investments. Selling means admitting we made a mistake and giving up all hope of better performance. "The reluctance to realize losses affects everyone, professionals and amateurs alike," he says. "The difference is, professionals have a sell discipline."

 

Got a rotten fund you can't bring yourself to sell? Prof. Statman's advice: You may find it easier to bail out if you first identify another fund that you really want to own. "Instead of getting rid of a loser, think of it as finding a winner," he suggests.

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