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Mutual Funds

Mutual Funds. Things we should know…. Mutual Fund Industry. Total assets managed exceed $5.7 Trillion Y/E 1990 total was $1 trillion Source: Financial Resource Corp, 8/02 Over 9,000 mutual funds 50 million + individuals hold mutual fund shares

jonah-hill
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Mutual Funds

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  1. Mutual Funds Things we should know…

  2. Mutual Fund Industry • Total assets managed exceed $5.7 Trillion • Y/E 1990 total was $1 trillion • Source: Financial Resource Corp, 8/02 • Over 9,000 mutual funds • 50 million + individuals hold mutual fund shares • Source: Common Sense on Mutual Funds, John C. Bogle, John Wiley & Sons, Inc; 1999

  3. Trends that should worry us… • High fees • Boards of directors that don’t actively manage the shareholders’ interests • Mediocre returns

  4. Why the stock market? • Average yearly stock market returns • 1802-1997 • Total nominal return 8.4%, total real return 7% • 1926-1997 (Real=inflation adjusted) • Total nominal return 10.6%, total real return 7.2% • 1982-1997 • Total nominal return 16.7%, total real return 12.8% • Annual stock market volatility • 1802-1997 • St.Dev. Real annual return 18.1 • 1982-1997 • St.Dev. Real annual return 13.2 • Source: Stocks for the Long Run; Professor Jeremy J. Siegel, Wharton School, University of Pennsylvania

  5. Bond Market • Average yearly bond market returns • 1802-1997 • Total nominal return 4.8%, total real return 3.5% • 1926-1997 • Total nominal return 5.2%, total real return 2.0% • 1982-1997 • Total nominal return 13.4%, total real return 9.6% • Annual bond market volatility • 1802-1997 • St.Dev. Real annual return 8.8 • 1982-1997 • St.Dev. Real annual return 13.6 • (Siegel)

  6. Historical returns • Stocks have historically earned higher returns than bonds. • In 187 rolling 10 year periods since beginning of stock markets, bonds have higher returns 38 times (1 in 5) • In 172 rolling 25 year periods over same time span, bonds outperform stocks only 8 times (1 in every 21) • (Siegel)

  7. Mutual fund returns • 30 year period (1967-1997) • Average General U.S. Equity Fund • Return of 10.8% (annualy) • S&P500 Index over the same period • Return of 12.5% • (this is the Index itself, NOT an index fund…) • (Bogle)

  8. Mutual Funds vs. the Index • The S&P 500 Index beats 80% of the mutual funds in an average year. • Statistically, this should be 50%… • How about the Broader Market? Wilshire 5000 Index has had the same return (13.7%) as S&P500 since 1970. • (Bogle)

  9. Index returns vs. Growth/Value (Large funds) • Over the last 15 years: • Wilshire 5000 Index returned 16.0% • Average growth / value fund = 14.1% • 33 of the 200 growth and value funds that SURVIVED the period beat the Wilshire 5000. • Odds: 1 in 6 • (Siegel)

  10. Index vs active returns • (cont. from previous slide..) Odds of beating the Wilshire 5000 by 3% points over the same period: • 1 in 200 • BY DEFINITION: Mutual funds as a group MUST provide GROSS returns equal to the Market • Last 15 years: Wilshire 5000=16.0%, Average of all funds gross return = 16.0%

  11. Distribution of Returns • GROSS mutual fund returns fit a normal distribution that one would expect to see when results were truly random (coin flipping) • Relative gross returns of mutual funds statistically have followed a random pattern: • Skill of managers appears to be a matter of luck • Managers have the additional handicap of COSTS to overcome

  12. Survivor Bias in Reporting Returns • Same 15 year period: • 20% of all funds FAILED to survive the period • Their returns (or lack of) are NOT reported at the end of the period (and thus are not counted against the aggregate)

  13. Survivor Bias • 10 Year period (1982-1991) • 18% of funds disappeared. • Survivors reported aggregate returns of 17.1% • If you count ALL funds, the more accurate return was 15.7% • The Survivor Bias artificially enhanced the reported returns by 1.4% • Source: A Random Walk Down Wall Street, Burton Malkiel, Princeton University • 15 year period ending in 1991 • Survivor bias added a phantom 4.2% to the annual gains • (Siegel)

  14. Survivor Bias • Additional data shows that from 1962-1993, fully ONE-THIRD of all stock funds disappeared. • Source: Mark Carhart • From 1988-1992 (very short period) • 100 of the original 686 funds disappeared • Malkiel • From 1993-1998 (Boom years for funds) • 600 FUNDS disappeared • Bogle

  15. Tax Efficiency • Average fund turnover (assets) = 80% • Bogle • During 15 years ended 1998, Vanguard’s Index fund beat 94% of all funds on a PRE-TAX basis, but beat 97% of all funds on an AFTER-TAX basis, due to lower asset turnover and higher tax efficiency • Vanguard, Inc.

  16. Tax Efficiency • Inefficiency leads to reduced overall returns for most actively managed funds

  17. How About Risk Management? • Active fund managers claim to provide added value because they can actively move money to cash to protect assets from market downturns. • Ideally, we would observe low cash positions as markets surged and high cash positions during declines. • Statistically, the exact opposite is true…

  18. Risk / Cash management • Last three market declines: • Active funds held very low cash positions (4%) • Last three market advances: • Active funds had very high cash positions. (11%) • As measured by standard deviation, Mutual funds (14.8%) are actually riskier than both S&P500 (14.3%) or Wilshire 5000 (14.0%) Index Funds… • Bogle • The Truth?…Managers are statistically no better at guessing than you are…

  19. Impact of fees on return • Average fund fees 1.4% • Average Index fund fees 0.2%

  20. Gross market return – Cost = Net market return • All investors own the entire stock market. Active + Passive investors total return must = the gross return of the market. • Fees / Costs by active investors are higher than those of passive investors. • Therefore, because they earn equal gross returns, passive investors must earn the higher NET return.

  21. Add up the shortfall… • Statistically speaking, active mutual funds must earn gross returns EQUAL to the market index. • Subtract for Costs, Survivor Bias, Taxes, and Higher Risk • The result is a HISTORICAL SHORTFALL of around 4% (depending on how one measures the impact of Survivor Bias).

  22. The ugly truth… • On a BEFORE TAX, BEFORE COST basis, actively managed funds have returns that are virtually equal to the indices. • AFTER TAX and other COSTS, Actively managed funds fall short on AVERAGE by 4.2% • AFTER TAX and other COSTS, Index funds fall short by 0.2%

  23. All Index Funds are Not Created Equal • Some have statistical returns that more closely match the index • Some have lower fees. • Shop around. • Vanguard is king of low costs…

  24. Indexing has grown in Acceptance • As results have stacked up over the past three decades, Investors have begun to accept Indexing as a legitimate strategy • Prominent professionals now concede that many ‘average’ individual investors would be best off buying and holding index funds…

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