Active vs. Passive Funds

Each quarter, Standard & Poors published a report that compares the performance of professionally mutual funds with the performance  performance of the S&P broad market indices.  The report is called the S&P Indices Versus Active Funds (SPIVA) Scorecard.  The S&P analysis shows that the most mutual funds fail to outperform the market indices.  As the time horizon gets longer, the performance by the professional fund managers gets worse.  The complete SPIVA can be found here. 

Here are some details from the S&P report for the 4th quarter of 2006. 

In 2006, domestic equity stocks indices led actively managed large-cap and small-cap funds.  The S&P 500 outperformed 69.1% of large-cap funds and the S&P SmallCap 600 led 63.6% of small-cap funds.  Conversely, 53.3% of mid-cap funds outperformed the S&P MidCap 400.

Over longer time periods, the market indices continue to outperform a majority of the actively managed funds.  Over the past three years (and five years), the S&P 500 has beaten 66.7% (71.4%) of large-cap funds, the S&P MidCap 400 has outperformed 65.1% (79.7%) of mid-cap funds, and the S&P SmallCap 600 has outpaced 80.6% (77.5%) of small-cap funds.

Why do the indices perform better than actively managed funds?  The short answer is that fund fees are higher and many funds do not do a good job of selecting stocks or managing their portfolios.  (Most funds are exceptionally good at collecting fees, however.) A number of funds fail to put the financial interests of their shareholders ahead of their own.  (The recent after hours trading scandal by fund managers is one example.  Another is excessive fees.)

Fees and expenses erode net return on mutual funds.  Management fees typically range from 0.5% to 1.5%.  (In contrast, management fees for some of the largest and oldest index funds are generally less than 0.2%.)  In addition, mutual funds also pay various transaction transaction and portfolios.  These fees are not disclosed in their prospecting but are contained in a statement of additional information.  Some have high turnover of assets.  High portfolio turnover raises expenses, increases tax liability, and often degrades performance.

When evaluating a mutual fund, it important to compare its performance to the index that most closely corresponds to the style of the fund (large cap value, mid cap blend, small cap value, etc.).  Also keep in mind that index funds tend to be more tax efficient.  Low turnover reduces the annual tax bite. 

How do you know if the mutual fund you are considering buying is one of the few that has outperformed market?  First, go to www.fundalarm.com and see how the fund has done over the past 1, 3 ,and 5 years.  FundAlarm.com compares fund performance with the benchmark that most closely corresponds to the fund style.   Second, look at the expense ration for the funds and sales commission.  Morningstar also compares fund performance with an index benchmark.  The management fee for a domestic equity fund should not exceeds 0.8%.  Pass on any funds that charge a load or 12b1 fee.

So what relevance does this have to the Model Investment?  First, it is not easy to beat the market.  We try but do not always succeed.  Second, it is important to minimize transaction fees and expenses. 

Good News for January

For the month of January, the Moose Pond portfolio is up 3.6% (in comparison with 1.4% for the S&P 500).  We may be back on track.  As of today, Feb 2, the portfolio return is up 4.5%, compared with 1.95% for the S&P 500.  That is good news! 

This month we sold UTStarcom (UTSI) for a loss of $717 and Investors Financial (IFIN) for gain $199.  We are 6.8% in cash.  We will be using some of that cash to round out our holdings of Walgreens (WAG) and will park the rest in the Vanguard Total Market Index (VTI).

Getty Images really took off this month, up 15%.  They did better than the analysts expected.  We are back in the black for that stock. 

We have two stocks that have doubled since we bought them.  Lowes (LOW), one of our first stocks, is up 248% for an annualized return of 22.4%.  Factset Research Service (FDS) is up 123% for an annualized return of 32.3%.  We need a few more stocks like them.

You can see the entire portfolio at Manifest Investing.

Annual Report for 2006

In 2006 we had a total return of 6.1%. The value of a unit increased from $13.097 to $13.894. While our return was positive, it lagged behind most of the major market indices. For the first time, we are slightly behind the S&P 500 for a five year period (5.9% vs. 6.2%). Portfolio turnover was about 10%. You can find the annual report for Moose Pond Investors here.

More information about the performance of individual stocks in 2006 can be found in the diversification report and performance report.

How Are We Doing?

So how are we doing so far this year on return? The answer is OK, but not as well as we should be doing. We have an internal rate of return of 7.3% year to date. (Internal rate of return takes into account when we receive funds. It is a more accurate measure of performance.) 7.3% is in line with the Wilshire Large Growth Stock index which is up 8.5%. However, some of the broader market indices have done much better, such as the the Wilshire 5000 which reflects the total market, is up 13.2% for the year.

How we are doing depends on the index to which we compare our portfolio performance. Here is a table showing year to date return data taken from the Wall Street Journal as of Wednesday, November 22.

Note that value stocks and small stocks have out performed both large and growth stocks. This has been a trend for a number of recent years. If you want to compare investment returns by asset class (large, small, value growth, etc.) take a look at the Callan Periodic Table of Investment Returns.

As you can see from the matrix on the right, our portfolio is weighted heavily toward large growth stocks. It was only some recent purchases of GYI and VTI that improved our style balance. Large growth stocks have not done as well as the smaller stocks and the value stocks this year. We need to include more small and medium size companies in our portfolio. It may be inconsistent with an NAIC approach, but we also need some value stocks. Value stocks are generally defined as ones have lower price to earnings or low price to book ratios.

The next two graphs compare our portfolio return over the past 12 months with two Morningstar indices. The first graph compares our return to the Morningstar large growth index. Our return tracks that index fairly closely.

The second graph, below, compares our return with the Morningstar U.S. market index. This is a broad index that includes all stocks. We are not doing as well as that index.

+GYI +WAG -ACS -MMC

Based on our email discussion, we sold Affiliated Computer Services and Marsh & McClennan Companies. We took an initial position in Getty Images and Walgreen Co. (The links will take you to the stock selection guide we used.) We can purchase more of these when either of these stocks dip in price.

These two additions have raised the overall quality rating (now 70.3) and the projected average return (12.3%). See portfolio dashboard here.

Looking at portfolio diversification, we are diversified across seven sectors. We are still weighted a little too heavy in the health care sector. Here is table from Morningstar showing our actual diversification.

Walgreen Company (WAG)

SSG and PERT | Google Stocks | Company Website

We purchased an initial position in Walgreens on November 22. Here is the stock selection guide we used for the purchase decision.