To read the accounts in the popular press of last year's mutual fund performance is to understand the frustration felt by many investors.
Exhibit A: Barron's annual fund family ranking issue earlier this year doctored the headline “The Best Fund Families” by crossing out the word “Best” and substituting “Least Bad.” Exhibit B: USA Today cancelled its annual “Mutual Fund All Stars” feature this year, refusing to grant All Star status to funds that beat the market but still lost money.
Certainly no portfolio manager feels good about losing money for shareholders. But it seems that many writers, and investors, are disappointed that equity funds did not sidestep the decline. There is scant if any public praise for a manager who beats the S&P by 700 basis points when that still translates to a decline for the year of 30 percent, as it did last year.
This disconnect between what investment professionals would describe as solid out-performance while average investors would label it abysmal points to a clear failure in expectations. What exactly is it that a portfolio manager can be expected to deliver through active selection of securities?
The verdict delivered by the media seems to be that the portfolio manager should know when to be in the market and when to be out of it. Tactically allocating a major portion of the portfolio to cash last year, according to this view, would have protected shareholders from the “risk” of stocks and spared them much of the decline in asset values.
But wait a minute. Is this really what a portfolio manager should be expected to deliver? And how does this jibe with the fundamental tenets of long-term equity investing?
Those tenets include the notion that the long-term bias in the market is upward, that nobody can consistently predict the market's future direction, and that owning broad exposure to the market over a long time horizon (emphasis on long) will provide superior returns, even when that horizon includes bear markets like the one that dominated last year.
Sophisticated investment professionals such as managers of major pension plans have these tenets in mind when they allocate portions of the plan to equity managers. Among the largest plans, typically these equity allocations will be split between passive and active managers. As you know, passive managers, or indexers, subscribe to the idea that neither timing market entry and exit points nor actively selecting securities will consistently produce better performance than the broad market index over time. Active managers, by contrast, hold that security selection through fundamental or quantitative analysis can add value over time either through adding incremental return, or lower risk — or a combination of the two — relative to the index.
What these pension fund managers typically do not expect of their active managers is that incremental return will be achieved by timing the market. A pension fund consists of many different sleeves in different asset classes, with projected long-term return assumptions assigned to each in an attempt to match the assets of the fund with its liabilities — the pension payments owed to retirees over time. In the asset sleeves that are dedicated to equities, the manager is expected to own equities, not cash. In these professionals' view, raising cash is a bet against the index that increases so-called tracking error, and therefore increases risk rather than lowers it. Portfolios that are hiding in cash risk missing market rebounds, which tend to happen very fast.
A manager who delivers incremental return above the index of 100 or 200 basis points a year through active security selection provides a powerful compounding mechanism over the long term. But that value, again, is somewhat lost on the investing public in a year like 2008.
The problem with trying to time the market is twofold. One is the fact that the marketplace for investment products like mutual funds is increasingly dominated by the “professional buyer.” Industry consultants and analysts at b/ds make decisions about which funds to add to platforms (such as asset allocation or retirement plans) based on the funds' performance attributes. The portfolio manager is expected to manage within the mandated discipline, such as large cap core, and not to tactically allocate to cash based on market conditions — a decision the advisor typically makes with clients at the individual portfolio level. In this sense the retail marketplace for mutual funds is becoming more like the institutional marketplace for pension funds.
Secondly, it is extremely difficult, if not impossible, to consistently predict the future direction of the market. Remember that fundamental tenet of long-term investing — that the long-term bias in the market is upward? Portfolio managers are unlikely to beat that long-term upward bias through timing entry and exit points. Active managers can add value and earn their fee over time by adding modest levels of incremental return and lower risk than the market, not through clairvoyance.
So while mutual funds have certainly taken their lumps in this challenging market, their value proposition is in many ways stronger than ever when one looks at many of the alternatives. The past year has seen many leveraged investors wiped out, unsuspecting investors bilked by a massive Ponzi scheme, and some non-diversified investments lose almost all their value. Mutual funds are obviously not immune to bear markets, but, over time, their key attributes — professional management, diversification, liquidity, and full transparency — have helped them weather market storms. These have been hallmarks of the open-end mutual fund since the first one, Massachusetts Investors Trust, was introduced 85 years ago.
Investors have suffered a crisis of confidence, but one thing history has shown us is that markets eventually rebound, and owning a well-diversified portfolio that includes equities as a long-term bet on the growth of the U.S. (and global) economy still provides the best opportunity to keep ahead of inflation in funding retirement and other long term goals.
Jim Jessee is president of MFS Fund Distributors, Inc.