My Key Takeaways From Chapter 9 and Commentary 9 of the Intelligent Investor. Part 10/16. To Be Continued.

Chapter 9 Investing in Investment Funds

Those that are redeemable on demand by the holder, at net asset value, are commonly known as “mutual funds” or (open-end funds”). Those with nonredeemable shares are called “closed-end” companies or funds; the number of their shares remains relatively constant.

There are different ways of classifying the funds. One is by the broad division of their portfolio, they are “balanced funds” if they have significant (generally one-third) component of bonds, or “stock-funds” if their holdings are nearly all common stocks. (There are some other varieties here, such as “bond funds,” “hedge funds,” “letter-stock funds,” etc.) Another distinction is by their method of sale. “Load funds” add a selling charge (generally about 9% of asset value on minimum purchases) to the value before charge. Others, known as “no-load” funds, make no such charge; the managements are content with the usual investment-counsel fees for handling capital. Since they cannot pay salesmen’s commissions, the size of the no-load fund tends to be on the low side. The buying and selling prices of the closed-end funds are not fixed by the companies, but fluctuate in the open market as does the ordinary corporate stock.

*Table 9-1 Management Results of 10 Large Mutual Funds

Commentary on Chapter 9

Top of the Charts

*Figure 9-1 The Crash-and-Burn Club

Figure 9-1 shows what happened to the hottest funds of 1999. This is yet another reminder that the market’s hottest market sector in 1999, that was technology-often turns as cold as liquid nitrogen, with blinding speed and utterly no warning. And it’s a reminder that buying funds based purely on past performance is one of the stupidest things an investor can do.

Financial scholars have been studying mutual-fund performance for at least a half century, and they are virtually unanimous on several points:

• The average fund does not pick stocks well enough to overcome its costs of researching and trading them;
• The higher a fund’s expense, the lower its returns;
• The more frequently a fund trades its stocks, the less it tends to earn;
• Highly volatile funds, which bounce up and down more than average, are likely to stay volatile;
• Funds with high past returns are unlikely to remain winners for long

The First Shall Be Last

There better a fund performs, the more obstacles its investors face:

1. Migrating managers
   When a stock picker seems to have the Midas touch, everyone wants him-including rival fund companies.
2. Asset elephantiasis
   When a fund earns high returns, investors notice-often pouring in hundreds of millions of dollars in a matter of weeks. That leaves the fund manager with few choices-all of them bad. (1) Keep that money safe for a rainy day-low returns on cash will crimp the fund’s result. (2) Put the new money into the stocks he already owns-probably gone up. (3) Buy new stocks he didn’t like well.
3. No more fancy footwork
   By keeping them tiny, the sponsor can use these incubated funds as guinea pigs for risky strategies that work best with small sums of money, like buying truly think stocks or rapid-fire trading of IPOs.
4. Rising expenses
   With operating expenses averaging 1.5%, and trading costs at around 2%, the typical fund has to beat the market by 3.5% points per year before costs just to match it after costs. The typical fund holds on to its stocks for only 11 months at a time.
5. Sheepish behavior
   As a fund grows, its fees become more lucrative-making its managers reluctant to rock the boat.

Tilting the Tables

When you add up all their handicaps, the wonder is not that so few funds beat the index, but that any do. And yet, some do. What qualities do they have in common?

1. Their managers are the biggest shareholders.
2. They are cheap.
3. They dare to be different.
4. They shut the door.
5. They don’t advertise.

Most fund buyers look at the past performance 1st, then at the manager’s reputation, then at the riskiness of the fund, and finally (if ever) at the fund’s expenses. The intelligent investor look at those same things-but in the opposite order.

Know When to Fold ‘Em

So when should you sell? Here a few definite red flags:

• A sharp and unexpected change in strategy
• An increase in expenses
• Large and frequent tax bills
• Suddenly erratic returns

As the investment consultant puts it, “If you’re not prepared to stay married, you shouldn’t get married.” Fund investing is no different. If you’re not prepared to stick with a fund through at least 3 lean years, you shouldn’t buy it in the first place. Patience is the fund investor’s single most powerful ally.