Earlier this week, I stood in front of a microphone and boomed this out to a large audience:
“You will not find an independent study anywhere, suggesting that you have decent odds selecting actively managed mutual funds that will beat the market indexes”
Then I went on to suggest that after reading more than 300 personal finance books, I’ve never seen a book suggest this either.
But since then, just for kicks, I went for a search. And the search ended when I found Louis Lowenstein’s exceptional book, The Investor’s Dilemma. A professor at Columbia Law School, he penned the book in 2008 with one startling assertion: You can find actively managed mutual funds that beat the markets.
First of all, let’s be clear about one thing. He’s not a fan of the actively managed mutual fund industry. In fact, if he could stuff it in a sack with a bunch of rocks, he’d probably toss the whole industry into a deep lake. He’d let the fund managers, salespeople, and their owners thrash it out in that bag for a while, but he’d eventually yank them out and hang them out to dry, before assigning them to roadside cleanup. The image is mine, but the abhorrence for the industry is definitely Lowenstein’s.
Rightfully, he sees most actively managed fund companies as self-serving entities that promise more than they can deliver. They have no consideration for their investors’ taxes (because they churn their holdings) and they grow larger and larger—accentuating their inefficiency—as they collect more and more assets from uneducated investors who are almost certain to underperform the indexes.
Lowenstein sees index funds as a great alternative to most actively managed funds. But he doesn’t stop there. He’s out to prove that the Holy Grails of the investment world do exist, and that you can find them. You can find funds that beat the indexes, he suggests.
First, he eliminates the mutual fund families that most of us have heard of:
The American Funds get skewered by Lowenstein for their “pay to play” scandals and their unfair remunerations, given to brokers who sell their funds. The fact that the fund company grows like a behemoth without closing its larger funds to new investors showcases that The American Funds company isn’t out for the investor—it’s out for itself. The larger a specific mutual fund grows (from salespeople stuffing investors’ money into them) the less efficient those funds are going to be, going forward.
Fidelity doesn’t escape the same wrath, for the same basic reasons.
He goes on to hammer publically traded fund companies (as he should) that have a tug-o-war battle going on between what’s best for their companies’ investors, and what’s best for those who invest in the funds. Who wins that battle? You’re naive to think that their mutual fund investors do. Fiduciary duties are jeopardized at the expense of the funds’ investors, of course. Some of these fund companies include Alliance Capital, Ameriprise Financial, Eaton Vance, Federated, Franklin Resources, Janus, Neveen, T. Rowe Price and Waddell & Reed. Each of these fund companies trade on the stock market. Trust me, it’s better to own shares in their stocks than it is to own their funds.
Yet Lowenstein thinks he can pick funds that beat the market
His arguments, in the book, are compelling. If you can find value oriented fund managers who are patient, disciplined, with relative low fee structures, low portfolio turnover, who own shares in their funds, who have reputations for closing large funds to new investors when they grow unwieldy….then you can find funds that trounce the indexes.
He gave 10 such examples that have crushed the market indexes. And as further support for these funds, he wanted to show how smart managers could sidestep falling markets or market silliness by choosing carefully selected stocks only, without diversifying into too many individual companies. Choosing the years between 1999 and 2003, he showcased how each of these funds trounced the S&P 500 index. Have a look at the list below, from page 26 of his book.
| Average Annual Returns: 1999-2003 | Annual Return |
| Clipper Fund | +11.9% |
| FPA Capital | +15.29% |
| First Eagle Global | +17.02% |
| Legg Mason Value | +4.43% |
| Longleaf Partners | +10.94% |
| Mutual Beacon | +10.28% |
| Oak Value | +2.63% |
| Oakmark Select | +15.43% |
| Source Capital | +15.22% |
| Tweedy Browne American Value | +4.87 |
| Average Annual Return for the 10 above | +10.8% |
| Return for the S&P 500 Index | -0.57% |
| Average annual advantage over the index | +9.43% |
My personal dilemma
As many of you know, I have also easily beaten the stock market index—leaving it soundly in my dust over the past decade, after purchasing individual stocks. My investment club has done the same thing.
But recently, I sold $700,000 worth of individual stocks to fully index my portfolio. Did I make the wrong move?
I don’t think so. No matter what happens, going forward, my investments will be in the 90th percentile, in terms of performance. The enemy of the great plan is the perfect plan. Reaching for that perfect plan (at least in the world of investing) is like reaching over the edge of a ravine to pluck a pretty flower. You might fall. Do it enough times, and you surely will. I’d rather have 90% of the cliff’s flowers brought to me each morning, rather than trying to collect all of them by venturing precariously over a railing.
But was Lowenstein on to something?
We know what John Bogle and Burton Malkiel would say, relating to my bolded question. They would suggest that there’s no way of knowing what funds are going to perform well ahead of time. True, there will always be funds that beat the market indexes, but these great men suggest that nobody can tell what they’ll be, ahead of time.
Lowenstein says that’s hogwash.
Let’s find out.
The above returns end in the calendar year, 2003. Lowenstein’s book was published in 2008, so we can assume that these funds probably did very well from 2003 to 2007, or he wouldn’t have included them in his book. If they had underperformed the markets from 2003 to 2007, somebody would have called him on it.
Now, despite what we assume will be a good run of performances for those funds to the point of Lowenstein’s book’s publication, let’s put those funds to a longer test.
His performances went to the end of 2003. If we use Morningstar to track their respective performances, how would they have done from January 1, 2004 to today (March 12th, 2011)?
If Lowenstein is right, they would have crushed the S&P 500. And why not? From 2004 to 2007 we had a Bull Market. Stocks everywhere rose exponentially. But the great money managers of the world could have (so the story goes) saved our money from the precipitous drop of 2008/2009. They would have sold when they forecasted that the market was going to plunge, or they would have sold on the way down—only to buy their stocks back when the market was at a cheaper level. That’s what a smart value investor can do, as Lowenstein suggests in his book. In theory, it seems like an easy way to crush an index that’s hinged 100% to the stock market.
Ready to put his funds to the test?
I’ll relieve some of the tension if you want. Of the 10 funds lauded by Lowenstein, 7/10 of them lost to the S&P 500 index from January 2004 to March 12, 2011. This is before taxes. True, three of them did extraordinarily well, but how are you going to know which of the “Super funds” would rock, if you were trying to forecast that ahead of time. The book suggests that they are all Superfunds. Yet 70% of them lost to a simple index fund without a clever manager at the helm.
Here are the results:
| Average Annual Returns: January 2004 to March 12, 2011 | Overall return |
| Clipper Fund | +2.5% |
| First Eagle Global | +98% |
| FPA Capital | +92% |
| Legg Mason Value | -32% |
| Longleaf Partners | +36.9% |
| Mutual Beacon | +37.3% |
| Oak Value (name changed, see ticker RCAPX) | +24% |
| Oakmark Select | +34% |
| Source Capital | +76% |
| Tweedy Browne American Value | +41% |
| Average Annual Return for the 10 above | +41.4% |
| Return for the S&P 500 Index | +41.8% |
| Deficit compared to the index | -0.04% |
In 2004, there’s no way that you’d know which 3/10 of these funds would beat the market index ahead of time, over the seven following years.
And it’s more depressing than that. If you bought all of these funds, you would have lost narrowly to the market index before taxes. But if you owned these funds in a taxable account, you would have lost about 0.25% annually in taxes, relative to the index fund. I’m being generous to the actively managed funds when assuming a 0.25% annual albatross, compared to the index. The deficit could end up being much higher than that. Compound that 0.25% over seven years, and you can add a further 1.7% advantage to the index fund over the performance of the super funds.
Mr. Lowenstein,
By no means am I suggesting that you’re not a bright man. I love your book, and I plan to commend you personally on it, with a postcard from Singapore.
But could it be a lot harder than you think it is to pick actively managed mutual funds that will beat the market indexes?
