Beating the Street (9 page)

Let's assume, then, that the day after you've bought all your stocks, the market has a major correction and your portfolio loses 25 percent of its value overnight. You berate yourself for gambling away the family nest egg, but as long as you don't sell, you're still far better off than if you'd bought a bond. Beckwitt's computer run shows that 20 years later, your portfolio will be worth $185,350, or nearly double the value of your erstwhile $100,000 bond.

Or let's imagine an even worse case: a severe recession that lasts 20 years, when instead of dividends and stock prices increasing at the normal 8 percent rate, they do only half that well. This would be the most prolonged disaster in modern finance, but if you stuck with the all-stock portfolio, taking out your $7,000 a year, in the end you'd have $100,000. This still equals owning a $100,000 bond.

I wish I'd had Beckwitt's numbers when I made my presentation to the nonprofit organization we've been talking about, because then
I might have tried to talk them out of owning any bonds. At least we decided to increase the percentage of assets invested in stocks, which is a step in the right direction.

The mix of assets having been decided, the next step is to figure out how to invest the bond portion. I'm no bond fan, which explains why this discussion is going to be short. That I'd rather be touting stocks should be apparent by now, but I'll put aside my favorite subject to say something about bonds as a safe place to keep your money. They aren't.

People who sleep better at night because they own bonds and not stocks are susceptible to rude awakenings. A 30-year Treasury bond that pays 8 percent interest is safe only if we have 30 years of low inflation. If inflation returns to double digits, the resale value of an 8 percent bond will fall by 20–30 percent, if not more. In such a case, if you sell the bond, you lose money. If you hold on to it for the entire 30 years you're guaranteed to get your money back, but that money (the principal) will be worth only a fraction of what it's worth today. Unlike wine and baseball cards, money is cheapened with age. For example, the 1992 dollar is worth one third of its 1962 ancestor.

(It's interesting to note that at present the much-disparaged money-market fund is not necessarily the disaster it's made out to be. With inflation at 2.5 percent and the money markets paying 3.5 percent, at least you're 1 percent ahead of the game. If interest rates rise, so will the money-market yields. I'm not saying you can live on a 3.5 percent return, but in the money market at least you run no risk of losing your capital. The low-fee money-market funds now offered by several investment houses have made this product more attractive. And since low interest rates are not likely to last forever, this is a far safer place to be invested than long-term bonds.)

Another fallacy about bonds is that it's safer to buy them in a fund. No doubt it is, if you're talking about corporate bonds or low-rated junk bonds, because a fund can limit the risk of default by investing in a variety of issues. But a bond fund offers no protection against higher interest rates, which is by far the greatest danger in
owning a long-term IOU. When rates go higher, a bond fund loses value as quickly as an individual bond with a similar maturity.

You can make a halfway decent case for investing in a junk-bond fund, or in a blended fund that offers a mix of corporate and government paper that produces a better overall yield than you could get from investing in a lone bond. What I can't figure out is why anybody would want to invest all his money in an intermediate- or long-term government bond fund. A lot of people do. More than $100 billion is invested in government bond funds today.

I may lose some friends in the bond-fund department for saying this, but their purpose in life eludes me. Anyone who buys an intermediate-term government bond fund and pays the .75 percent in annual expenses for salaries, accounting fees, the cost of producing reports, etc., could just as easily buy a 7-year Treasury bond, pay no fee, and get a higher return.

Treasury bonds and bills can be purchased through a broker, or directly from a Federal Reserve bank, which charges no commission. You can buy a 3-year note, or T-bill, for as little as $5,000 and a 10-year or 30-year Treasury bond for as little as $1,000. The interest on the T-bill is paid up front, and the interest on the bond is automatically deposited in your brokerage account or your bank account. There's no fuss.

The promoters of government-bond funds like to argue that expert managers can get you a better return via their well-timed buying, selling, and hedging of positions. Apparently, this doesn't happen very often. A study done by the New York bond dealer Gabriele, Hueglin & Cashman concludes that in a six-year period from 1980 to 1986, bond funds were consistently outperformed by individual bonds, sometimes by as much as 2 percent a year. Moreover, the bond funds did worse relative to bonds the longer the funds were held. The benefits of expert management were exceeded by the expenses that were extracted from the funds to support the experts.

The authors go on to suggest that bond funds try to maximize current yield at the expense of total return later. I have no evidence of my own to support or refute their conclusion, but I do know that the owner of a 7-year bond can at least be confident of getting his or her money back at the end of 7 years, whereas the owner of an intermediate-term bond fund had no such assurance. The price this investor gets on the day he or she sells the fund will depend on the bond market.

Another mystifying aspect of bond-fund mania is why so many people are willing to pay an upfront sales charge, a.k.a. load, to get into government funds and the so-called Ginnie Mae funds. It makes sense to pay the load on a stock fund that consistently beats the market—you'll get it back and then some in the fund's performance. But since one U.S. Treasury bond or Ginnie Mae certificate is the same as the next, there is little a manager of one of these kinds of funds can do to distinguish himself from competitors. In fact, the performance of nonload bond funds and funds with loads is almost identical. This leads us to Peter's Principle #5:

There's no point paying Yo-Yo Ma to play a radio.

To handle the bond portion of the portfolio for our nonprofit organization, we hired seven people—two traditional bond managers to invest the bulk of the money, three convertible bond managers (see page 72), and two junk bond managers. Junk can be very lucrative, if you buy the right junk, but we didn't want to bet the ranch on it.

In one respect, a stock fund is no different from a stock. The only way to benefit from it is to keep owning it. This requires a strong will. For people who can be scared out of stocks, investing in a stock fund doesn't solve the problem. It's a common occurrence for the best-performing funds to decline more than the average stock during a correction. During my turn at the helm at Magellan, on the nine occasions when the average stock lost 10 percent of its value the fund sank deeper than the market, only to rise higher than the market on the rebound—as I'll explain in more detail later. To benefit from these comebacks, you had to stay invested.

In letters to the shareholders, I warned of Magellan's tendency to get swamped in choppy waters, on the theory that when people are prepared for something it may disturb them, but it won't unnerve them. Most, I think, remained calm and held on to their shares. Some did not. Warren Buffett's admonition that people who can't tolerate seeing their stocks lose 50 percent of their value shouldn't own stocks also applies to stock funds.

People who can't tolerate seeing their mutual funds lose 20–30 percent of their value in short order certainly shouldn't be invested in growth funds or general equity funds. Perhaps they should choose a balanced fund that contains both stocks and bonds, or an asset allocation fund—either of which offers a smoother ride than the ride they'd get on a pure growth stock fund. Of course, there's less reward at the end of the trip.

Turning our attention to the baffling assortment of 1,127 equity funds on the market today, we arrive at Peter's Principle #6:

As long as you're picking a fund, you might as well pick a good one.

This is easier said than done. Over the last decade, up to 75 percent of the equity funds have been worse than mediocre, failing to outgain the random baskets of stocks that make up the market indexes, year in and year out. In fact, if a fund manager has even matched the market's performance, he or she has ranked in the top quartile of all funds.

The fact that so many funds with investments in the stocks that make up the averages can manage to do worse than the averages is a modern paradox. It seems illogical that a majority of fund managers cannot achieve an average result, but that's the way it's been—1990 was the eighth year in a row in which this widespread failure to match the gains recorded by the popular S&P 500 index occurred.

The causes of this strange phenomenon are not entirely known. One theory is that fund managers are generally lousy stockpickers and would do better to scrap their computers and throw darts at the business page. Another is that the herd instinct on Wall Street has produced so many camp followers that fund managers only pretend to pursue excellence, when actually they are closet indexers whose goal in life is to match the market averages. Tragically, their residual creativity gets in their way, so they cannot do even a decent bad job, as also occurs with brilliant writers who try and fail to produce simpleminded best-sellers.

A third and more charitable theory is that the stocks that make up the averages—especially the S&P 500 index—tend to represent large companies that in recent years have enjoyed a great run. It was harder to beat the market in the 1980s than it was in the 1970s. In the 1980s, you had massive buyouts of companies that were included
in the S&P indexes, which caused the prices of the stocks in the indexes to go up. You had a lot of foreigners investing in our market, and these foreigners preferred to buy large-company stocks with famous names. This added to the upward momentum.

In the 1970s, on the other hand, many of these popular brand-name stocks (Polaroid, Avon Products, Xerox, the steels, the automakers) faltered because the companies themselves were doing badly. Quality growth companies such as Merck continued to thrive, but their stocks went nowhere because they were overpriced. A fund manager who avoided these big stocks had a huge advantage back then.

A fourth theory is that the popularity of index funds has created a self-fulfilling prophecy. As more big institutions invest in indexes, more money is poured into index stocks, causing them to rise in price, which results in index funds outperforming the competition.

So should you forget about picking a managed fund from among the hundreds on the market, invest in an index fund or a couple of index funds, and be done with it? I discussed this option with Michael Lipper, the number-one authority on mutual funds. He provided
Table 3-3
. It compares the record of a large group of managed funds, here called the General Equity Funds, with the S&P 500 Reinvested, which is essentally the same thing as an index fund, minus the very small fees charged by index-fund operators.

Lipper's chart illustrates what we've already said, that throughout the recent decade the index funds beat the managed funds, and often by a wide margin. If you had put $100,000 in the Vanguard 500 index fund on January 1, 1983, and had forgotten about it, you would have celebrated January 1, 1991, with $308,450 in your pocket, but you'd have had only $236,367 in your pocket if you had put the money in the average managed equity fund. The eight-year winning streak for the indexes was finally broken in 1991.

Over 30 years, the managed funds and the indexes are running neck and neck, with the managed funds having the slightest edge. All the time and effort that people devote to picking the right fund, the hot hand, the great manager, have in most cases led to no advantage. Unless you were fortunate enough to pick one of the few funds that consistently beat the averages (more on this later), your research came to naught. There's something to be said for the dart-board method of investing: buy the whole dart board.

Table 3-3. MUTUAL FUND MANAGERS VERSUS S&P 500®

The S&P 500 Index has outperformed the average mutual fund manager in 8 of the past 10 years …

Lipper himself sees the futility in the annual search to find tomorrow's winning fund manager. The evidence tells us that it's probably a useless exercise. Still, hope springs eternal. The human spirit is alive and well on Wall Street, and investors are not about to stop sifting through the fund lists, looking for a fund that can consistently beat the averages.

Several colleagues and I took on this challenge for the nonprofit organization already mentioned. We spent hours reviewing the résumés and performance records of 75 different money managers, and from this number we chose to interview 25.