Recently the Wall Street Journal has run a couple of articles critical of a number of mutual funds for both buying Facebook shares at or near the initial public offering price and, more recently, for disposing of those shares after a short holding period.
Clearly, to date, the Facebook IPO has been an unmitigated disaster. The IPO price was $38 per share on its May 18 debut. The stock closed at $21.92 per share on August 6, a drop of some 42 percent.
While the Journal makes some very valid points, I think overall the articles miss the bigger picture as far as owning actively managed funds. If one purchases an actively managed mutual fund (or separate account, annuity sub-account, closed-end fund, ETF, etc.) they are buying that manager’s skill and their ability to achieve some expected result.
There is a whole other debate about whether an investor should stick with lower cost index funds or passively managed ETFs vs. actively managed funds. (For the record I am a fan of indexing and index mutual funds, and ETFs comprise a significant portion of my client’s assets.) But I still do use a number of carefully selected actively managed mutual funds as well.
In my opinion if you are looking at such funds you should evaluate the “whole picture.” Typically when evaluating a mutual fund, the starting points of an analysis include:
Track record relative to its peers. It’s useless to compare a mid-cap growth manager to one who invests in foreign large value stocks. Note a stellar track record may not indicate success going forward so it is incumbent upon you to look further and understand what is behind that historical success.
Performance across various market conditions. How did the fund do in the market drop of 2008-09 compared to its peers? How has it done in the market rally since March of 2009? Is this performance within your expectations for the fund?
Expenses. How does the fund compare to its peers?
Alpha and Sharpe ratio. These are measurements of the fund’s risk-adjusted return and to me are indicators of the value (or lack thereof) added by the manager.
Management tenure. It is not uncommon for a successful fund manager to move on to greener pastures, especially if wooed by a competitor. If the manager or managers who compiled the fund’s great track record are gone this is a big red flag, though not always a deal killer. A number of years ago the long-time manager of a foreign fund that I like left. Two of her underlings took over and have done an even better job. Investing is about people, but it’s also about process.
Gain or loss of assets. This is huge, especially if the fund invests in small- or mid-cap stocks. Many funds have compiled a great track record with a low asset base. One of the truisms of investing is that money chases performance. Once a fund does well, new money can often poor in. It can be tough for the manager to find enough good ideas in which to invest this new money. Case in point is Fidelity Magellan. This fund was managed by the legendary Peter Lynch and posted some fantastic numbers. Money poured in, Lynch left, and the fund has been decidedly mediocre ever since.
In other words, when evaluating an actively managed mutual fund you need to look at the “entire body of work.” I’ve never studied this, but I would bet that even among the best active mutual funds managers there are a sizable percentage of stock purchases that didn’t work out over the years. Using baseball as an example, a player who hits safely 30 percent of the time on a consistent basis is considered a superstar. In the NBA a 50 percent shooting percentage is considered outstanding.
Don’t get me wrong, there are many valid criticisms to be made of the mutual fund industry. However I don’t think focusing on the purchase and subsequent sale of one holding, even one that so far has been a lousy investment, is the right focus when evaluating a mutual fund manager.
Roger Wohlner, CFP®, is a fee-only financial adviser at Asset Strategy Consultants based in Arlington Heights, Ill., where he provides advice to individual clients, retirement plan sponsors, foundations, and endowments. Read more about Roger here.