Best Funds? Look to the Best Managers

The Annual Awards for Excellence in Fund Management prompt some thoughts on investment performance and priorities from S&P's Philip Edwards

If you're shopping for mutual funds, one place to start is the list of winners in the Annual Awards for Excellence in Fund Management presented by BusinessWeek and Standard & Poor's (see BW, 3/21/05, "The Best Fund Managers"). Philip Edwards, managing director of S&P's Investor Services, points out that in the previous two years, the winning managers "outperformed their peers for the subsequent years."

The 18 winners (nine of them repeaters) cut across styles and sizes, including value and growth, mid-cap and large-cap, equities and bonds, and international. One category missing is small-cap, which Edwards explains as resulting from the fact that many small-cap funds have closed to new investors. Also missing are sector funds, although Edwards says S&P does recommend at least two of them, the AIM Real Estate Fund (IARAX ) and the Jennison Natural Resources Fund (PGNAX ).

One winning manager has an unusual distinction: He's a descendant of Daniel Boone, Daniel Boone III, who runs the Calvert Social Investment Equity Fund (CSIEX ), a large-cap blend fund that specializes in socially responsible investments.

These were a few of the points Edwards made in an investing chat presented Mar. 22 by BusinessWeek Online and S&P on America Online, in response to questions from the audience and from Jack Dierdorff of BW Online. Following are edited excerpts from this chat. AOL subscribers can find a complete transcript at keyword: BW Talk.

Q: Before we get into mutual funds, do you have any comments on the way the market is going?

A:

The market is lacking leadership at this time and is demonstrating some concern over oil prices and inflation. However, we still expect some growth in the market this year, but it will probably be in the mid-single digits.

Q: S&P and BusinessWeek are out with the 2005 Excellence in Fund Management Awards. How are the winners selected?

A:

We go through a process of initially identifying funds using the BusinessWeek screens that look at five years of performance, and we take the top performers in each style. From that, we undertake in-depth research into a wide range of areas, including manager experience and tenure, the level of expenses, the discipline of the investment process, and the availability to retail investors. From this information, we select a very short list of funds that have demonstrated strength across all of those factors.

Q: Is an award to a manager a good sign that his or her fund would be a good pick for investors?

A:

We think so. The proof is in the fact that this is the third year we've picked managers for the awards. In the first two years, the winning managers outperformed their peers for the subsequent years.

Q: Can you give us a sampling of the best managers and their funds?

A:

Sure. In the large-cap growth area we have a well-known group and a well-known fund -- the T. Rowe Price Growth Stock Fund (PRGFX ), managed by Robert Smith. In the mid-cap value area, we like the Goldman Sachs Mid-Cap Value Fund (GCMAX ). On the international side, we favor Tweedy Browne Global Value (TBGVX ). And on the fixed-income side, we really like Dodge & Cox Income Fund (DODIX ).

Q: Looking over the list, I don't see any small-cap funds. Any ideas why?

A:

Absolutely. Small-cap funds have been closing lately. As a result, it's hard to find a good manager [of a fund] that's still open. We'd rather not make a recommendation there than recommend someone who doesn't meet our standards. An alternative here would be an index fund.

Q: How about bond funds among your winners, Phil?

A:

We have four bond funds on our list. The Dodge & Cox fund that I mentioned before; Harbor Bond Fund (HABDX ), managed by Bill Gross, the same person who runs Pimco Total Return (PTRAX ); the Managers Bond Fund (MGFIX ); TCW Galileo Total Return Bond Fund (TGLMX ); and finally Eaton Vance Municipal Bond Fond (ETMBX ).

Q: What insights do you derive, Phil, from the shifts among the winners in the three years of the awards?

A:

Well, frankly there haven't been a whole lot of shifts in the winners. We have tried to maintain some stability in the list because we believe funds are long-term investments. Where there has been change, it's mainly because the fund has closed to new investors, or there has been some manager turnover. What we've primarily been doing is adding to the list of winners each year.

Q: I don't see any sector funds in the awards list -- are there any S&P recommends?

A:

No, at this point we don't have recommendations on too many sector funds. However, we do like the AIM Real Estate Fund and the Jennison Natural Resources Fund.

Q: Calvert Social Investment Equity is a repeat winner -- is this a sign that virtue can bring reward if an investor wants to be socially responsible?

A:

Yes. The Calvert Fund, which happens to be run by a descendant of the original Daniel Boone, is required to invest only in those companies deemed to be socially responsible by analysts at Calvert. For example, they will screen out companies involved with nuclear energy, guns, and liquor.

Q: In this market, will value funds outperform growth funds? In a rising interest rate environment, what type of funds do best?

A:

Well, typically what you'd see in the later stages of a recovery is that value funds would do better. However, value funds have done very well throughout this entire recovery. So it will be interesting to see whether they will continue to outperform.

Q: What do you think of the Davis Opportunity Fund (RPEAX )?

A:

We have followed this fund for a while, and it has an excellent track record. It's a bit of a go-anywhere fund -- meaning that its style is likely to change over time as the manager pursues opportunities in his stock selection. As a result, it's sometimes difficult to use within an asset allocation.

Q: Do you believe it is time to reduce holdings in REIT mutual funds?

A:

Yes. At the very least, an investor should be trimming from back from the stellar gains the [funds] have been experiencing. I'm not sure anyone should be absent in an asset class, so I wouldn't totally sell out. But I certainly would be looking to take profits.

Q: You mentioned asset allocation -- do you have a suggested mix of funds for a long-term investor?

A:

Well, of course, the BusinessWeek award winners are a good place to start. And some of the ones I mentioned earlier are among those. I think a diversified strategy would need to consider: Large-cap growth, large-cap value, mid-cap, small-cap, international equity, as well as intermediate and short-term fixed income. You can find most of these on the BusinessWeek list.

Q: Do you believe American Funds to be a solid mutual-fund company despite recent problems, and if so, which funds?

A:

I absolutely believe that the portfolio management of the American Funds is among the best available. The current problems involve the distribution of the funds, not the management of the assets. The funds that we like include Growth Fund of America (AGTHX ), EuroPacific Growth (AEPGX ), and Bond Fund of America (BFAFX ).

Q: Fidelity funds such as Blue Chip Growth (FBGRX ) and Growth & Income (FGRIX ) have underperformed. Are they too big?

A:

Probably. Funds of that size typically lag behind their peers in performance. So I believe a good deal of the underperformance could be attributed to that. The exception to this are the American Funds, which are large by any measure of assets, but continue to perform well.

Q: Fidelity New Millennium (FMILX ), Neal Miller -- good past. What's next?

A:

Well, frankly, the record that we have for it shows a good deal of weakness. It has consistently underperformed its peers over the last five years. If this track record continues, I would guess that the next question would probably be put to Mr. Miller.

Q: What is your opinion on Janus? The returns on Janus Global Opportunities (JGVAX ) have been good -- should I stick with it?

A:

Janus seems to be rounding the corner and beginning to become more stable again. The turnover in staff is behind them. The inquiries seem to be largely behind them, and they appear to be getting their house back in order again. The Global Opportunities Fund appears to have a decent track record. Before buying into that fund, however, I would compare it to some other global offerings such as Tweedy Browne.

Q: Three Fidelity funds are best on the Nightly Business Report -- International Small Capital (FISMX ), Strategic Dividend & Income (FSDIX ), International Discovery (FIGRX ) -- your opinion?

A:

The International Discovery Fund is a very good fund, but unfortunately it recently closed to new investors. The Strategic Dividend & Income Fund is brand new -- launched in December of 2003. Because of its short track record, it's hard to come to any meaningful conclusions on it. The Fidelity International Small-Cap Fund is also relatively new, having been launched in the fall of 2002. It has a short but good track record. However, one year ago it underwent a management change. So I would want to wait to see how the new managers work out before coming to any conclusions.

Q: Do low-cost index funds have a role in a diversified portfolio?

A:

Absolutely. They can serve a very important role as part of a low-cost, low-turnover strategy. For example, you might want to use index funds for the U.S. equity part of the portfolio and use actively managed funds for areas such as real estate, international, and fixed income.

Q: I have been debating whether or not to invest in the Jensen J Fund (JENSX ) in the future -- what are your thoughts?

A:

This is a very attractive portfolio for people who are interested in the more conservative side of growth investing. It will not do as well as its peers in more momentum-driven markets. But it will provide a lot of protection in more defensive or uncertain markets, like those we're experiencing today. It has an extremely low turnover of about 5%, but it's also very concentrated -- around 30 holdings, with half the portfolio represented in the top 10.

Q: Do you like any Vanguard index funds? Vanguard Total Stock Index Fund (VTSMX )?

A:

I don't think there's a huge difference between a total market and an S&P 500 index fund. You're not going to experience a significant difference in returns between the two, because so much of the total market index is weighted to the large-capitalization stocks. As a result, I would suggest finding a large-cap index, as well as small- and mid-cap indexes, and utilizing these three in combination, depending on your risk profile. Vanguard can offer exposure to all three.

Q: Fund managers have been criticized for not doing as well as the market -- is that still an issue?

A:

Yes. There's an ongoing debate about whether active managers can outperform indexes, given all the costs associated with active management. Our own studies show that you have an equal chance of winning with an index or an active manager when investing in large-cap funds. However, the S&P indexes have beaten most active managers in the small- and mid-cap segments of the market over the last five years.

Q: How important are costs when choosing a fund?

A:

Critical. S&P's studies show that mutual funds with below-average expense ratios outperform their peers that have higher-than-average expense ratios. I think this is an item that all investors should factor into their analysis.

Q: I've heard that index-fund managers can vary in how well their fund actually mirrors the index. Is this a concern?

A:

Yes, it is, especially with small- and mid-cap funds. Success in indexing is all about mass and scale. The funds that have larger assets are better able to track the index efficiently. And Vanguard owns at least two-thirds of the assets indexed in small- and mid-caps. So they have an advantage in these areas.

Q: The Baron family of funds has done well recently. How does their record compare to other funds?

A:

The Baron Asset Fund (BARAX ) has done very well, with a very impressive long-term track record. But it's closed to new investors. The Baron Growth Fund (BGRFX ), which remains open, also has a very strong track record against other small-cap funds. But its asset size is very large, at $4 billion. This would raise questions in my mind about whether the track record will continue. The Baron Partners Fund (BPTRX ) is relatively new but has had a good start with a very strong showing over the last year.

Q: What advice would you leave for mutual-fund investors today, Phil?

A:

Well, I would say investors should remain diversified, should be deliberate and patient with their investments, and should not invest based on recent trends in the market. Through a disciplined and long-term investment strategy, investors are most likely to be successful.

Edited by Jack Dierdorff

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