Mutual-fund investors, it seems, are people of faith. They entrust their kids' college money, their life savings, or a slice of every paycheck to fund managers they've never met. So far, millions of the faithful have been rewarded. In 1996, the average diversified U.S. equity fund, which represents the bulk of fund assets, earned a total return of 19.3%. Roll in international and specialty funds, and the average is 17.7%. And the multiyear returns are comfortably in the double digits as well.
Good as the fund averages look, however, they all trail the comparable returns of the Standard & Poor's 500-stock index. That has spurred much of the movement toward index funds--those managed solely to match an index but not to beat it. In fact, the largest index mutual fund, the $30.3 billion Vanguard Index 500, pulled in $8 billion last year and is now the third-largest equity fund (table). Even at industry giant Fidelity Investments, where stock-picking is king, the marketing power is being placed behind index funds.
For the most part, individuals see their investments in absolute terms rather than the relative terms that matter to professional investors. Most investors would prefer to earn 17% and underperform the market in a good year for stocks than beat the S&P in a bad year and earn just 4%.
Still, to know whether you've put your trust in the right funds, you need to know how your funds are performing both absolutely and relatively. That's why BUSINESS WEEK's Mutual Fund Scoreboard is a tool you can't do without. We've got performance data on 885 equity mutual funds. We look at total returns both pretax and aftertax, fees and expenses incurred in buying and owning funds, and insights into the funds themselves, including cash, foreign investments, and largest holdings. The data are prepared for BUSINESS WEEK by Morningstar Inc.
What distinguishes this scoreboard from the rest of the pack is its attention to risk. The best funds are not those with the highest returns last year but those with the best risk-adjusted returns over the past five years. Forty-eight funds earned three upward-pointing arrows (table, page 66). Those are a diverse lot, ranging from Fidelity Select Electronics Fund, with an enormous 36.5% average annual return, to the Merger Fund, with just 10.8%. What these funds have in common is that compared with all other funds with at least five years of history, they earned superior returns for the level of risk they took with shareholders' money.
We've also added a second set of guides, called "category ratings" (table). These, too, are based on risk-adjusted total returns over the past five years. But for these ratings, funds compete only against others in their investment category, not against all other funds, as in the overall BUSINESS WEEK rating. (Eight smaller categories of funds remain unrated because they have too few funds with long enough track records.)
With category ratings, investors can still spot top-performing funds in underperforming sectors. Consider the precious metals funds, whose high volatility and low returns place them at the bottom of the overall ratings. Still, if you wanted to invest in a gold fund as a way to diversify, we have two with three-up-arrow ratings for that category: Midas Fund and Scudder Gold Fund.
NEW LENS. The way we categorize diversified funds is also new this year. Gone are vague objectives such as "growth" and "growth and income." For diversified U.S. funds, we now use categories such as "large-cap value" down to "small-cap growth" (table, page 63). "Institutional investors have looked at money managers this way for years," says Robert Cummisford, a senior consultant at Ibbotson Associates Inc., a Chicago investment-consulting firm. "It tells you much more than what the funds use in their prospectuses." Adds John Rekenthaler, publisher of Morningstar Mutual Funds: "These new categories look at funds not by what they say about themselves but how they actually invest." Morningstar recently adopted these categories in its publications.
You should consider diversifying among the categories. The market tends to swing back and forth between favoring growth and value stocks and between large- and small-caps. In the first half of 1996, for instance, small-cap growth funds soared, riding the tide of rising earnings and high expectations for technology and health-care stocks and initial public offerings of almost any ilk.
The market stumbled in early summer, but when it bounced back investors turned more cautious and bought larger- cap stocks. Small-cap growth funds finished the year with an average return of 16.6%, while large-cap value and large-cap growth each garnered 21.1% returns (table). Small-cap value funds, which shun momentum stocks for more prosaic investments such as shares of manufacturers, retailers, and banks, ended the year with an average 21.8% return, well ahead of their growth-oriented competitors.
Right now, value funds--large-cap, mid-cap, and small-cap--dominate the list of top-performing, three-up-arrow funds. They don't grab the attention that high-flying growth funds sometimes command, but they have generally outperformed growth funds over the past five years. Even more important, they often earn high ratings because they are less volatile than the growth funds.
"Our data show that growth funds have higher long-term returns, but I suspect investors make more money in value funds," says Morningstar's Rekenthaler. "Because the funds are less volatile, investors tend to hold on to them longer and let the profits roll. With growth funds, they often buy when they've already gone up and sell when they're down."
STARS. Some of the value funds that earned top ratings are repeat performers, such as Fidelity Destiny, both I and II, Fidelity Equity-Income, both I and II, and the Michael F. Price's Mutual Series funds: Franklin Mutual Beacon Z, Franklin Mutual Qualified Z, and Franklin Mutual Shares Z. Last fall, Price sold the fund group to Franklin Resources, hence the Franklin name. Unlike Franklin's other funds, the Z shares are no-load, but they're restricted to investors who were in the funds prior to the takeover. Those buying since get a different share class and pay a load.
There are some worthy funds on the list for the first time. Veteran fund manager Charles M. Royce placed two of his: Royce Micro-Cap Fund and Royce Premier Fund. Both are small-cap value funds, which usually invest in companies that lack the pizzazz and high valuations of software or Internet stocks. But that's where the similarity ends. Royce Premier concentrates on the "larger" small-caps, the 1,400 or so companies with market values of $300 million to $1 billion. "That's where most mutual funds and institutional investors go when they want small-caps," he says. To make money in a fairly efficient market, he says, "you need to take bigger bets." So Royce Premier holds about 50 stocks that are concentrated in a few sectors.
Royce Micro-Cap stalks completely different prey: the 6,500 public companies, most of them little-known, with market caps between $5 million and $300 million. Since the micromarket is much less liquid, Royce takes a totally different tack. He holds 150 stocks in a broadly diversified portfolio.
Babson Value Fund, another top-performing fund, makes its money among the large-cap value stocks. That's the kind of fund that's buying the dogs even when they're in the headlines. "Kmart was a terrible performer when we owned it in 1995," says Nick Whitridge, who has run the fund since 1984. "But it was one of our best in 1996." Whitridge, too, runs a concentrated portfolio, with just 40 stocks and a strict buy-and-sell discipline that keeps turnover to a minimum: No new stock can be added unless the fund sells an existing one."
Two new names on the top-performers list are run by the same team of managers with almost the same portfolios and nearly identical returns--AARP Growth & Income Fund and Scudder Growth & Income Fund. Main difference is that the Scudder fund owns tobacco stocks. The AARP fund, in deference to the wishes of the sponsoring American Association of Retired Persons, does not.
PIPSQUEAK. Both funds follow a strategy called "relative dividend yield," buying dividend-paying stocks when their yield is high relative to their yield history. "The yield is high usually because the stock is out of favor," says Robert Hoffman, lead manager for both funds. "When the yield becomes relatively low, it's usually because the stock's price is going up." The sell signal usually comes when the yield is relative low. The funds end up in the blend category, says Hoffman, because he buys stocks when they are value plays and holds them as they become growth plays.
Several other funds that have earned three up-arrows for the first time are small and little-known. The $150 million Mairs & Power Growth Fund, based in St. Paul, Minn., has beaten the S&P 500 in each of the past seven years, a feat few funds can claim. Even more interesting is the portfolio: 80% of the companies in the fund are headquartered in the Upper Midwest. "We don't purport to be a regional fund," says manager George A. Mairs. "It just works out this way. These are the companies we know best." The other pipsqueak is $131 million Sound Shore Fund, based in Greenwich, Conn. T. Gibbs Kane Jr., one of the fund's managers, says that an important factor for the fund's success is a strict discipline that, like Babson Value Fund, keeps the fund focused on its 40 stocks. "When we're right about a stock, we have enough of it to make an impact," says Kane.
The scoreboard's new category ratings have also turned the spotlight on some hot stars, such as Janus Worldwide Fund. Portfolio manager Helen Young Hayes takes a "bottoms up" approach to global investing. She first identifies investments by focusing on companies. Many international funds take the opposite tack--identifying the countries or markets first, then finding stocks to fill in the allocation.
"The companies I like most," says Hayes, "have a product or service that's exportable. That way, they're not bound by the local economy." But she doesn't rule out purely local companies--such as Telebras, the Brazilian telecommunications giant--if the growth prospects are strong. Hayes also manages Janus Overseas Fund: Worldwide includes U.S. stocks and Overseas does not.
As you peruse the scoreboard, watch for these features:
Management changes. Fund giant Fidelity Investments has 75 funds in the scoreboard--and 41 of them have had new portfolio managers during the past year. Fidelity has always moved managers around every few years to broaden their experience, but these changes were exacerbated by an exodus of managers. The outline of a head-and-shoulders figure next to the fund name indicates a change in portfolio manager took place in the last year. Of the 48 funds that took top honors for overall performance, four got new managers in the past year. But 14 of the funds have the solid head-and-shoulders figure next to their names, indicating a manager who has been on the job for at least 10 years.
Foreign holdings. The column "% foreign," a new feature in the scoreboard, shows just how much of the fund's portfolio is invested in non-U.S. companies. The average diversified U.S. fund is only about 6% invested abroad, but that's probably 6% more than most investors realize. If this figure runs above 10% in a fund that represents a large part of your portfolio, you should count the non-U.S. portion with your international holdings to get a better reading on the asset allocation of your portfolio. Sometimes, the surprise is how little of the fund is invested abroad. Smallcap World Fund has just 38% invested overseas, and despite its name, Morningstar considers it a domestic fund.
Best and worst quarters. Another new feature in the BUSINESS WEEK scoreboard are the returns earned in the best and worst calendar quarter of the past five years. These figures can give you a sense of how volatile the fund can be. Specialized funds usually have bigger swings than diversified funds. The best quarterly return in the Scoreboard was 46.2% recorded by Invesco Strategic Gold Fund in last year's first quarter. Its worst showing was -21.3%, in the fourth quarter of 1994. But funds that invest in emerging growth companies, characterized by high price-earnings ratios, can also have wide swings.
One thing these "worst quarter" figures don't tell you is how the funds behaved in a bear market. There hasn't been one in the past five years. But many funds went through some pretty ugly periods in 1992 and 1994, bad enough to give you a taste of the bear. Take each of your fund's worst quarterly returns and double it. If you can live with that kind of one-quarter loss for one of your funds, you're ready for whatever the markets may give you.
The scoreboard starts on page 82.