Beat Your Fund Manager

Even smart investors make foolish choices. In their search for hot returns, mutual fund shareholders often buy near the market peak. Then after experiencing big losses, the same shareholders sell near the trough. One of the most notable examples of such self-defeating behavior occurred during the rise and fall of Janus Twenty in the 1990s. In 1996, the fund had $4 billion in assets and an annual total

Even smart investors make foolish choices. In their search for hot returns, mutual fund shareholders often buy near the market peak. Then after experiencing big losses, the same shareholders sell near the trough. One of the most notable examples of such self-defeating behavior occurred during the rise and fall of Janus Twenty in the 1990s. In 1996, the fund had $4 billion in assets and an annual total return of 27.9 percent. Seeing such strong results, investors raced into the fund, which had $36 billion in assets by 1999. The newcomers arrived at exactly the wrong time: In 2000 the fund lost 32.4 percent

Since 1994, such patterns of investor behavior have been chronicled by Dalbar, Inc., the Boston-based consulting firm. According to the company's 2003 report, the Standard & Poor's 500-stock index returned 12.2 percent annually over the previous 19 years, while the average equity fund investor earned only 2.6 percent.

But lately a curious thing seems to have occurred. Some investors have apparently wised up. In 2004, the average investor outdid the S&P 500, according to Dalbar. And since then, more investors have been investing for the long term. “Plenty of people still make mistakes, but I do believe that many investors are getting smarter,” says Lou Harvey, president of Dalbar.

Harvey thinks fund shareholders have gotten smarter for several reasons. First, people have learned from the past. Having seen technology funds crash in the downturn that began in 2000, investors have stopped trying to beat the market. Instead, many savers have begun buying and holding stable funds. The change is particularly noticeable in 401(k) plans where many investors are selecting balanced or retirement-date funds. In addition, more investors are using advisors. “Most advisors have been steering their clients prudently,” says Harvey.

Measuring Investor Returns

To get a picture of how investors are behaving, Morningstar recently created a new data category called investor returns. The measure takes into consideration changes in a fund's assets as well as total returns. That way Morningstar can tally how the average dollar in the fund actually performed. In contrast, conventional total return figures are calculated by assuming all dollars were invested at the beginning of the term in a lump sum. Advisors can now compare a fund's investor return and total return. In many cases the two numbers are very different. “If a fund's investor return is low, then the typical investor did poorly, and there is reason to be cautious — no matter what the total return is,” says David Kathman, a Morningstar analyst.

Investor returns vary considerably from company to company and fund to fund. During the ten years ending Dec. 31, 2006, the average equity fund at Janus Capital Group produced a respectable total return of 9.2 percent annually, ahead of Vanguard Group, which returned 8.7 percent. But because of decisions made by individual investors, Janus shareholders only scored investor returns of 3.3 percent annually, while Vanguard shareholders generated results of 8.4 percent.

The variance in investor experience depends partly on the attitude of the fund companies, says Kathman. “Fund shops that emphasize long-term investing aren't going to attract the kind of people who aim to get quick profits.”

Companies with high investor returns tend to avoid faddish funds and refuse to run adds promoting hot returns, says Kathman. Examples of fund families with relatively high investor returns include American Funds, Dodge & Cox and Franklin Templeton.

Many of the best-performing fund companies specialize in low-volatility funds. Seeking to find whether high-volatility funds encourage bad investor behavior, Kathman studied returns from all the diversified domestic stock categories. In every category, low volatility funds produced higher average investor returns than high-volatility funds did.

Should you avoid high-volatility funds altogether? Not necessarily, says Louis P. Stanasolovich, president of Legend Financial Advisors, a registered investment advisor in Pittsburgh. “You want one or two high-volatility funds to diversify a portfolio,” he says. “But most portfolios should have a low volatility overall.”

Smart Funds

Below are some funds that rank high in terms of investor returns, according to the Morningstar data. The total returns are competitive — and the investor returns top the total returns. Such funds have encouraged investors to act intelligently, buying low and waiting patiently.

During the past three years, Columbia Dividend Income A has produced a total return of 15.4 percent annually, while the investor return has been 20.8 percent. The fund manages to keep investors aboard by holding high-quality companies that pay rising dividends. Such blue chips produce steady results and rarely disappoint. One big holding is Exxon Mobil. “The company plans to raise the dividend about 8 percent a year, and you can bet that they will,” says portfolio manager Dick Dahlberg.

Another steady workhorse is Mutual Qualified, which looks for cheap companies with solid cash flows. Portfolio manager Anne Gudefin wants to pay 60 cents for a dollar's worth of assets. Because they have already fallen, such stocks may pose little downside risk. In order to find values, Gudefin often buys companies with big problems. To insure that the stocks will recover, Gudefin looks for catalysts that will eventually save the day. “Often we like to buy when a new management team is taking over a troubled company,” she says.

The fund often holds big slugs of cash, which helps to cushion results in downturns. A favorite holding is Carrefour, a French retailer, which just got a new management that is promising to cut costs and streamline operations.

Pioneer Cullen Value is another fund that maintains low volatility by looking for deep-value names. Portfolio manager Jim Cullen only takes stocks that fall into the bottom 20 percent of the market based on price-earnings ratios. He often buys downtrodden companies that seem likely to turn around because of cost cutting or growing international sales. A strong holding lately has been computer maker Hewlett-Packard. “We bought the stock when nobody wanted it, and we will sell when the price-earnings ratio gets up to the market multiple,” says Cullen.

Contrarian picks have helped RiverSource Diversified Equity Income avoid big losses. Portfolio manager Steven Schroll buys cheap stocks that have tarnished images. Lately he has been buying insurance stocks with price-earnings ratios of around 7. A big holding is ACE, an insurer. “People are afraid that hurricanes or terrorism [will] cause big losses for the insurers,” says Schroll.

While growth funds can give shareholders rocky rides, Oppenheimer Capital Appreciation avoids the trouble by sticking with companies that have a sure advantage over rivals and seem likely to produce big earnings gains for the next three to five years. “We are looking for companies with patent protection or some other advantage that will not disappear anytime soon,” says portfolio manager Marc Baylin.

A big holding is Google. Baylin figures that the search engine is in the early stages of its development. With more advertisers turning to the Internet, Google will attract growing revenues — and help Oppenheimer encourage shareholders to stay for the long term.

KEEPING SHAREHOLDERS FOR THE LONG TERM

At these steady funds, the actual investor returns, on average, exceed total returns posted by the fund.

Fund Ticker 1-Year Return 3-Year Return 5-Year Return % Rank 5-Year Investor 5-Year Return
Columbia Dividend Income A LBSAX 19.9% 15.4% N/A N/A N/A
Mutual Qualified A TEQIX 19.1% 18.3% 12.5% 3% 12.8%
Oppenheimer Capital Appreciation A OPTFX 8.3% 8.8% 5.8% 47% 6.7%
Pioneer Cullen Value A CVFCX 11.2% 17% 12.8% 5% 15.5%
River Source Diversified Equity Income A INDZX 13.1% 19.1% 13.6% 2% 14.4%
Source: Morningstar Returns through 4/30/07.
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