Beating the Street (11 page)

What if you had bought the funds with the best 5- and 10-year performances and held on to them for 5 years? In the case of the best 5-year performers, you would have done no better than the S&P index, and in the case of the 10-year performers you would actually have ended up lagging the S&P by .61 percent.

The lesson here is: don't spend a lot of time poring over the past performance charts. That's not to say you shouldn't pick a fund with a good long-term record. But it's better to stick with a steady and consistent performer than to move in and out of funds, trying to catch the waves.

Another major issue is what happens to a fund in a bear market. This, too, is a complicated subject. Some funds lose more than others, but gain more on the rebound; some lose less and gain less; and some lose more and gain less. This last group is the one to avoid.

One excellent source of information on this subject is the
Forbes
Honor Roll, published in that magazine every September. To make the
Forbes
list, a fund has to have some history behind it—two bull
markets and at least two bear markets.
Forbes
grades each fund (from A to F) on how it has fared in both situations. It gives the name of the fund manager and how long he or she has held the post, the fund expenses, the p/e ratio, and the average annual return over ten years.

Getting on the
Forbes
Honor Roll is tough, which is what makes this a good place to shop for funds. You can hardly go wrong by choosing one with an A or B rating in both kinds of markets.

Out of the 1,200 or so equity funds in existence, only 264 go back as far as 1978, and of those 264, only 9 have shown a gain in every calendar year since. This list includes: Phoenix Growth, Merrill Lynch Capital A, Investment Company of America, John Hancock Sovereign, CGM Mutual, Nationwide, Eaton Vance Investors, Pax World, and Mutual of Omaha Income. The best performer of these, Phoenix Growth, has compiled a remarkable record—a compound annual gain of 20.2 percent since 1977. Eight of the nine have produced an annual gain of 13 percent or better.

Another matter that needs to be addressed is load versus no-load. If you buy a fund that carries a load (translation: sales commission), does that mean you're getting a better product? Not necessarily. Some successful funds charge a load, while other equally successful funds don't. If you plan to stick with a fund for several years, the 2–5 percent you paid to get into it will prove insignificant. You should not buy a fund because it has a load, nor refuse to buy one for the same reason.

The ongoing fees and expenses of a fund can certainly hamper its performance, which is where the index funds have the advantage, as we've seen. In comparing the past performance of one managed fund against another, you can ignore the fees. A fund's annual return is calculated after fees and expenses are deducted, so they're automatically factored into the equation.

Some people worry about the size of a fund, especially Magellan. Beginning in 1983, when Magellan's assets passed the $1 billion mark, I first began to hear the words “too big to succeed.” It was too big to succeed at $2 billion, and at $4 billion, and at $10 billion, and by the time I left it was too big to succeed at $14 billion. Presumably,
it was too big to succeed at $20 billion, the size it reached under Morris Smith.

For a year after Morris took over,
The Boston Globe
ran its “Morris Smith Watch” column, which might as well have been called “Watch Morris Smith Fail with a Fund That's Too Big.” After Morris's excellent results in 1991, the
Globe
dropped the column, but many people are still singing the “Your Fund's Too Big” blues. Now that Morris has left, it's Jeff Vinik's turn to succeed with a fund that's too big.

There are certain drawbacks to running a big fund. It's like a linebacker trying to survive on a diet of petits fours. He has to eat a considerable pile to get any nourishment out of them. A fund manager has the same predicament with shares. He can't buy enough shares of a wonderful small company for it to make any difference to the performance of the fund. He has to buy shares in big companies, and even with big companies it takes months to amass a meaningful quantity and more months to unload it.

These disadvantages can be overcome by skillful management. Michael Price has proved it with his Mutual Shares (this fund is now closed to new investors; Price also runs Mutual Beacon), and so did Morris Smith, my successor at Magellan.

Before we leave this subject, there are four other types of funds I'd like to discuss: sector funds, convertible funds, closed-end funds, and country funds.

Sector funds have been around since the 1950s. In 1981, Fidelity offered the first group of sector funds, allowing investors to switch back and forth between sectors at relatively low cost. An investor who was bullish on an industry (oil, for example) but had no time to study specific companies in the oil business could simply buy the oil and gas sector fund.

These sector funds were not designed to give the whimsical stockpicker a new opportunity to follow hunches. Alas, that's sometimes how they're used. Buying the oil and gas fund, as opposed to buying Exxon, will hardly protect you from losses if oil prices head south just as you've acted on a gut feeling that oil prices are headed north.

The best candidate for investing in sector funds is a person with
special knowledge about a commodity or the near-term prospects for a certain kind of business. It could be a jewelry store owner, a builder, an insurance adjuster, a gas station manager, a doctor, or a scientist, each of whom is in a position to follow the latest developments in, respectively, gold and silver prices, lumber prices, insurance rates, oil prices, government approvals for new drugs, or whether the biotech firms are beginning to turn out a marketable product.

If you're in the right sector at the right time, you can make a lot of money very fast, as investors in Fidelity Biotechnology discovered in 1991. The value of that sector fund increased by 99.05 percent in one year. But such profits can also disappear as quickly as they are made. Fidelity Biotech was down 21.5 percent through the first nine months of 1992. Technology sector funds were big winners in mid-'82-mid-'83, and big losers for several years after. Over the past decade, health care, financial services, and utilities have been the most profitable sectors, and precious metals the least.

On the theory that every sector in the stock market eventually has its day, I've begun to get interested in the gold sector again.

In my earliest years at Magellan, gold prices were soaring and people were avoiding the dentist because they feared having to pay for a gold cap even more than they feared the drill. In this era, the best-performing funds were gold funds, which had names like Strategic Investments or International Investors or United Services. To the casual observer, the gold funds sounded like general equity funds, a confusion that I found infuriating.

In the Lipper rankings for best-performing mutual funds over a five-year period, usually I'd be beaten out by a gold fund, which many people didn't realize was a gold fund. To the average investor, it looked as if other equity managers were doing a better job than I was, when in fact these number-one performers were specialists in a hot sector. Soon enough, the gold funds disappeared from the top of the Lipper list, and in recent years they've hit the bottom.

For the decade that ended June 1992, 5 of the 10 worst-performing funds in the U.S. market were gold funds. U.S. Goldshares, for instance, was up only 15 percent for this entire stretch when the average mutual fund tripled and quadrupled. You'd have done better in a money market, or U.S. savings bonds, even, than in a gold fund.

But with gold having been highly prized by the world's population since before the time of the Egyptians and the Incas, I doubt that we've seen its last hurrah. One of the charities in which I'm involved owns some gold shares, and I recently heard a presentation from some well-informed gold bugs. They point out that in the 1980s the decline in South African output was more than offset by new production from U.S., Canadian, Brazilian, and Australian mines. This created a gold glut, exacerbated by the dumping of gold by the former Soviet republics. They doubt the glut will continue.

The gold supply in new mines will run out soon, and meanwhile, the decade of low prices has discouraged companies from further exploration and development. This is likely to set up a nice situation in mid-decade. The demand for gold for jewelry and industrial uses will go up, while the supply goes down. And if inflation returns to double digits, people will once again buy gold as a hedge.

In addition, there is a “China factor” pushing up the gold prices. Chinese workers are becoming more prosperous, but they lack things to buy with their money. There's a limited supply of big-ticket items (cars, appliances, houses, etc.) that can be purchased, so the government is trying to relieve the frustration by allowing people to own gold. This policy is creating a whole new demand for the metal. The situation may repeat itself for other developing countries.

There are 34 gold sector funds on the market today—some that buy shares in South African mining companies, others that buy shares only in non-South African mining companies. A couple of hybrid funds are 50 percent invested in gold and 50 percent in government bonds. For the extremely skittish investor who worries about both the coming Depression and the coming Hyperinflation, this is an appealing mix.

This is an underrated way to enjoy the best of two worlds: the high performance of secondary and small-cap stocks and the stability of bonds. Generally, it is the smaller companies that issue convertible bonds, which pay a lower rate of interest than regular bonds. Investors are willing to accept this lower rate of interest in return for the conversion feature, which allows them to exchange their convertible bonds for common stock at some specific conversion price.

Customarily, the conversion price is 20–25 percent higher than the current price of the common stock. When the price of the common stock reaches this higher level and beyond, the conversion feature becomes valuable. While waiting for this to happen, the bondholder is collecting interest on the bond. And whereas the price of a common stock can fall very far very fast, the price of a convertible bond is less volatile. The yield holds it up. In 1990, for instance, the common stocks connected to the various convertible bonds were down 27.3 percent, while the convertible bonds themselves lost only 13 percent of their value.

Still, there are certain pitfalls to investing in convertible bonds. This is one field that's best left to the experts. The amateur investor can do well in one of the numerous convertible funds, which deserve more recognition than they get. Today, a good convertible fund yields 7 percent, which is far better than the 3 percent dividend that you get from the average stock. The Putnam Convertible Income Growth Trust, to name one such fund, has a 20-year total return of 884.8 percent, which beats the S&P 500. Few managed funds can make such a claim, as we've already seen.

At the nameless New England charity, we invested in no fewer than three convertible funds, because at the time convertibles seemed undervalued. How could we tell? Normally, a regular corporate bond yields 1½ to 2 percent more than a convertible bond. When this spread widens, it means convertibles are becoming overpriced, and when it narrows, the reverse is true. In 1987, just before the Great Correction, regular corporate bonds yielded 4 percent more than convertibles, which meant that the convertibles were extremely overpriced. But during the Saddam Sell-off in October 1990, convertible bonds were actually yielding 1 percent more than regular bonds issued by the same companies. This was a rare opportunity to pick up convertibles at a favorable rate.

Here's a good strategy for convertible investing: buy into convertible funds when the spread between convertible and corporate bonds is narrow (say, 2 percent or less), and cut back when that spread widens.

Closed-end funds trade as stocks on all the major exchanges. There are 318 of these at current count. They come in all sizes and varieties:
closed-end bond funds, municipal bond funds, general equity funds, growth funds, value funds, etc.

The main difference between a closed-end fund and an open-ended fund such as Magellan is that a closed-end fund is static. The number of shares stays the same. A shareholder in a closed-end fund exits the fund by selling his or her shares to somebody else, the same as if he or she were selling a stock. An open-ended fund is dynamic. When an investor buys in, new shares are created. When the investor sells out, his or her shares are retired, or “redeemed,” and the fund shrinks by that amount.

Both closed-end funds and open-ended funds are basically managed the same way, except that the manager of a closed-end fund has some extra job security. Since the fund cannot shrink in size due to a mass exodus of customers, the only way he or she can fail is to generate losses in the portfolio itself. Running a closed-end fund is like having tenure at a university—you can be dismissed, but you have to do something really awful to make it happen.

I've never seen a definitive study of whether closed-end funds, as a group, do better or worse than open-ended funds. On casual inspection, neither kind has any particular advantage. Superior performers in both categories appear on the
Forbes
Honor Roll of mutual funds, which proves that it's possible to excel with either format.

One intriguing feature of the closed-end funds is that since they trade like stocks they also fluctuate like stocks—a closed-end fund sells at either a premium or a discount to the market value (or net asset value) of its portfolio. Bargain hunters have excellent opportunities in market sell-offs to buy a closed-end fund at a substantial discount to its net asset value.