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Ninety million investors own mutual funds. And according
to a recent study by Yale professors Antti Petajisto and
Martijn Cremers, that means that about 30 million are
paying too much to do so. Am I one of the 30
million?
Who's overpaying? It's the folks who pay up for
active management of their investment dollars but end up
with a portfolio that trails the index because of the
high fees that get deducted from the account. That
unfortunate reality was true of funds that controlled
approximately 30% of mutual fund assets in 2003,
according to a recent article in The Wall Street
Journal. The Journal called these "closet index funds."
Our own fund guru and Champion Funds advisor Shannon
Zimmerman calls them good funds gone bad.
Clever names aside, funds like these are a real
danger to your investment dollars. That's because high
fees not only hurt your returns each year, but by
removing money from your account, they mute the
long-term effects of compounding -- where the real money
is made.
The best and the worst funds
The study calls out the once-famous and recently
maligned Fidelity Magellan (FUND: FMAGX) as a poster
child of passive active management. (To be fair, the
study is using data from the period before Fidelity
installed Harry Lange as the new head of Magellan.)
Simply put, less than 40% of Magellan's portfolio
differed from the S&P 500 in 2002. Yet Magellan still
charged investors 40 basis points more than the Vanguard
index offering. What's worse, Fidelity lost out to the
index by 1.6 percentage points that year. In other
words, the few bets it made contrary to the index didn't
work out anyway.
Outperformance, however, did correlate with the most
active funds, which beat the index by approximately 1.4
percentage points per year from 1990 to 2003. Consider
the model case of Fidelity Low-Priced Stock (FLPSX),
which posted an "active share" (a measure of how
different the fund is from its benchmark) of
approximately 90% in 2002. Not coincidentally, the fund
shredded the index to the tune of 16 percentage points.
Its 10-year annualized return is an even more impressive
15.8%, which puts its nearly 10 percentage points ahead
of the S&P 500. Current top holdings include Petroleo
Brasileiro (NYSE: PBR), DR Horton (NYSE: DHI), Safeway
(NYSE: SWY), Oracle (Nasdaq: ORCL), UnitedHealth (NYSE:
UNH), and Chesapeake Energy (NYSE: CHK).
The least active funds, on the other hand, trailed
the index by about 1.4 percentage points.
But do you have to pay up for quality?
Unfortunately, the most active funds also correlate
with the highest expense ratios -- they charge about
1.5% per year on average.
So what's the key to getting the most bang for your
investing dollars? Find the most active funds with the
lowest expense ratios. For instance, Fidelity
Low-Priced, which is closed to new investors, charges
just 0.94%.
Since Petajisto and Cremers' methodology is new, you
can't find their measure of "Active Share" on Fool.com,
Morningstar, or Yahoo! Finance. You can, however, find a
fund's R-squared score, which measures how closely a
fund's movements track those of its benchmark. While
it's not a perfect measure, it can also be a helpful
clue in determining whether your fund is a "closet
index."
Additionally, there are a few other traits that might
help you identify the market's best funds:
- Long-tenured management.
- A market-beating track record that the current
team has earned.
- Managers who invest in their own funds.
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