Mutual fund managers should come out of the closet

By DAVID MOON, Moon Capital Management, LLC
September 27, 2009

Is your mutual fund manager in the closet? No, I’m not suggesting that he plays hide-and-seek or is involved in some Perez Hilton scheme to attack evangelical beauty queens.

Does your manager purport to actively invest your funds, when either knowingly or unknowingly he simply mimics the S&P 500?

That is, is he a closet indexer?

Some investors make decisions on a stock-by-stock basis. When they identify something they decide is an attractive investment, they buy it.

Another strategy looks a bit more like Noah’s Ark portfolio management. Buy two of every kind.

Before you know it, the manager owns a couple of hundred stocks, representing most of the market capitalization of the S&P 500.

Proponents of these types of funds argue that being average is better than being worse than average – and since most mutual funds underperform the S&P 500, why not try to closely map your portfolio to that index?

Ignore for a moment that investors in these closet index funds are paying active management fees for the privilege of owning a slightly slimmed down version of the Vanguard Index 500.

The bigger risk is that in certain market conditions actively managed funds do outperform their indexed brethren.

Surprisingly, over the long-term, actively managed funds and index funds (including both the explicit and closet variety) return about the same. During specific different periods, however, that’s not necessarily true.

In the fifteen years ending June 30, 2009, the U.S equity mutual funds returned an annual average of 6.71 percent. The funds with more than 500 stocks returned 6.87 percent.

Since the first of this year, however, the return differential has been much more noticeable.

The funds with fewer stocks (which incidentally, also had a higher turnover ratio) returned 7.36 percent in the first six months of 2009, compared to only 4.52 percent for the over 500 stock crowd.

Admittedly, over a period as short as six months, performance is as much a matter of luck as almost anything else. The difference could simply be a momentary blip.

Or it could be the beginning of another of the vacillating periods in which being average isn’t so attractive.

The S&P 500 is a group of stocks selected by a committee at McGraw Hill. It is a misnomer to call it “unmanaged.” Stocks are regularly added and removed from the portfolio.

Presumably, it is done in an effort to make the list better reflect leading companies in leading industries of the U.S. economy. Stocks from ten sectors are represented at all times, irrespective of either their absolute or relative attractiveness as potential investments.

What if we have entered a period of economic activity in which certain types of businesses will have difficulty accessing debt capital at reasonable rates? What if investors are more concerned about risk than they have been in some time, and are willing to exclude from investing in companies that they deem too risky?

If that happens, who might come out of the closet?

David Moon is president of Moon Capital Management, a Knoxville-based investment management firm. This article originally appeared in the News Sentinel (Knoxville, TN).

Add me to your commentary distribution list.

MCM website