Source: shot97.com

I’m sure most parents of teenagers can relate to this scenario: it’s a quarter-past midnight, and curfew was at ten. Your teenager hasn’t called to say he’s okay, much less hurriedly sneaked in the backdoor. As a parent, you are understandably worried; a thousand worried thoughts are rolling through your mind.

In a similar (although clearly much less dramatic) fashion, investors should be aware of what their mutual fund manager is up to. Last week, I discussed a common mutual fund bad habit (read here) called closet indexing, and this week I want to give a real-life example of how it can happen. (To recap briefly, closet indexing is when a mutual fund that purports to be actively investing on your behalf, is actually just passively copying the index it is trying to beat. In other words, it’s basically just an index fund, with higher fees.) Research shows that closet indexing has become more and more popular over the last decade, and we put in a lot of effort to make sure we avoid these types of funds.

Why Active Investing

Why do investors buy active funds? Clearly, its because they believe the manager, because of his unique research, insights, experience and skill, can produce returns above the benchmark over the long term. A knowledgeable investor knows that active funds will not outperform every year, but over a market cycle, he/she expects that average returns will exceed the market net of fees. Otherwise, a rational investor would simply buy an index fund. However, a recent study by researchers at Yale shows that true active investing can and does indeed outperform.

The Fidelity Magellan Fund

One of the classic examples of an active fund that outperformed for many years is the Fidelity Magellan fund, run by the famous Peter Lynch. From 1977 to 1990, with Lynch at the helm, the fund enjoyed fantastic out-performance, including beating it’s benchmark by 150% during the last decade. Because of this, the fund attracted huge asset inflows, growing to over $100 billion in assets by the turn of the century.

This chart shows the Magellan fund’s performance under Lynch versus S&P 500 (green) and other Large Cap Growth stock funds (orange) from 1977 to 1990

However, the performance after Lynch left has been mixed, and by studying a measurement called “Active Share,” we can see why. (Active share is a simple measurement designed to reveal how “active” a fund is. It is measured on a scale of 0 to 100%, with higher scores showing a high degree of active management and lower scores revealing closet indexing. Any supposedly active fund with a score below 60% can realistically be called a “closet index fund.”) During the last few years of Peter Lynch’s tenure, the fund’s active share began to drop, even while assets rose substantially. This is somewhat typical for large funds as their assets base grows. After Lynch left in 1990, Jeffrey Vinik took over, and increased Active Share somewhat, but that was short-lived. He left the fund in 1995, and then Robert Stansky took over. Stansky managed the fund from 1996 to 2005, and during that time the fund performance was weak. The fund lagged the S&P 500 by about 1% per year, net of fees. That performance makes sense, when you consider that the fund was essentially just a closet index fund during that time. See the chart below.

The Magellan fund’s “Active Share” (measurement of divergence of investments from the index) from 1980 to 2009. Source: “Active Share and Mutual Fund Performance”, by Antti Petajisto, Jan. 15, 2013

By 2005, the fund’s closet indexing ways were becoming clear, and Fidelity was under some pressure to make the fund more active. As one can see from the chart, the new manager, Harry Lange, did exactly that.

Conclusion

The point of this example is two-fold: first, no fund can outperform by hugging it’s benchmark index. That much is obvious, but it bears out the importance of examining the holdings within a fund, their correlation with the index, and the manager’s propensity for convicted investing. Second, just because a fund has out-performed in the past, doesn’t mean it will continue to do so. Care has to be taken to make sure the same manager is still at the helm, he/she still invests the same way, and the temptation to hug the benchmark hasn’t taken hold. Sometimes, a fund’s success can be its own worst enemy.

At JPH Advisory Group, we spend a great deal of time and effort looking at these attributes, among many others, to determine the very best funds for our clients’ portfolios.