Tuesday, May 26, 2009

Best Performing Mutual Funds - 20 Years

"By periodically investing in an index fund..... the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb. 

On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you." - Warren Buffett in the 1993 Berkshire Hathaway (BRKaShareholder Letter

There are many thousands of open-ended mutual funds -- as well as an increasing number of exchange-traded funds (ETFs) -- to choose from for a retail investor these days.

This article, from 2007, lists the 20 best-performing open-ended mutual funds over a 20-year period. The number one fund (Vanguard Healthcare: VGHCX) produced a 16.84% annualized 20-year return. A 20-year record like those listed in this article is certainly no small accomplishment for a money manager.

Having said that, with all the funds to choose from, it is unlikely that an investor would have a mutual fund portfolio that performs anywhere near this well in the real world. Why?

First, the probability that an investor would have chosen (and held onto through the ups and downs) one of these 20 among all available funds is low (of course, there are quite a few others that did very well compared to a benchmark that just did not quite make this list). The fact is many funds do not even keep up with the S&P 500 because of fees, taxes, too much trading activity, and, well, poor investment decision-making.

Second, mutual fund investors themselves can be their own worst enemy. There's plenty of evidence that investors tend to buy more during the good times and sell during the not-so-good times which erodes long-term returns. So what fund investors actually earn ends up being much lower than the funds themselves.

The reason is simple: Investors attempt to time their investments and redemptions, often unsuccessfully.

They buy when others are fearless....sell the opposite. Not good.

From this extract of DALBAR's Quantitative Analysis of Investor Behavior (QAIB) that looked at 20-year returns through 2007:

"The results have shown, to varying degrees, that the average investor earns significantly less than mutual fund performance reports suggest...Investment return is far more dependent on investor behavior than on fund performance. Mutual fund investors who hold their investments typically earn higher returns over time than those who time the market."

Here are the results from DALBAR's more recent QAIB. According to the latest QAIB, the S&P 500 returned 8.35% over the 20 years that ended in 2008 while, on average, equity fund investors earned just 1.87% (less than the inflation rate of 2.89%). From this DALBAR press release:

"The dramatic events that continue to plague our financial markets have provoked panic, which exacerbates the ongoing carnage," said Lou Harvey, president of DALBAR. "For 15 years, QAIB has shown that investor returns lag what performance reports and prospectuses would lead one to believe is achievable. While those returns are, in fact, theoretically achievable, the reality is that investors are not rational, and make buy and sell decisions at the worst possible moments," he said.

Now, consider that each of the following boring stocks -- those often described as "defensive" -- produced total returns (incl. dividends) competitive with or better than the 20 best-performing funds over the same 20-year period.

Procter & Gamble (PG)
Pepsi (PEP)
Coca-Cola (KO)

That's just three examples. There are certainly others. Also, this isn't the only longer time horizon (i.e. choose another ~ 20-year period) that the above stocks -- along with others that have similar business characteristics -- have performed just fine. In other words, it's not unusual to find more than solid performance in other similarly long time frames even if that, of course, guarantees nothing going forward.

Now, while many of these boring stocks seem rather unlikely to do as well going forward on an absolute basis, their relative merits -- especially the best of these -- remain not insignificant.
(I mean, it would seem more than a little unwise to view that particular 20-year period as being anything less than exceptional; better to have more conservative expectations built into the investment process. There'll be no complaints if it turns out that being more optimistic was warranted.)

These are not just defensive stocks, they are quality businesses with attractive and durable core long-term economics. My preference among so-called defensive stocks (though there are certainly some fine alternatives) happens to be Philip Morris International (PM), and Diageo (DEO) despite the fact that they lack easy to confirm 20-year historical performance.*

Again, just because something that seems to be a higher quality investment has done well in the past guarantees nothing. Still, it's likely a mistake to discount these results as being just some one time anomaly or random real world special case without, at least, digging into this a bit deeper.

There are exceptions, of course, but generally the companies like Coca-Cola -- those that make and distribute leading branded small-ticket consumer products on a big scale -- have attractive long-term economics. The best among them are compounding machines that need not be traded (in fact, it's the attempt at trading that will likely hurts returns) though, as always, buying with a margin of safety matters. That means, for example, they can't be bought blindly at a time like the bubble of the late 1990s (it wasn't just tech stocks that were expensive) or during the "Nifty Fifty" era of the early 1970s. In both cases, stocks like Coca-Cola were selling at extraordinarily high multiples of earnings (30, 40, 50 times earnings and even higher). An investor can't pay that much and expect a good long-term result no matter how fine the companies themselves may be.

Otherwise, it's just not all that complicated.

"...most professionals and academicians talk of efficient markets, dynamic hedging and betas. Their interest in such matters is understandable, since techniques shrouded in mystery clearly have value to the purveyor of investment advice. After all, what witch doctor has ever achieved fame and fortune by simply advising 'Take two aspirins'." - Warren Buffett in the 1987 Berkshire Hathaway Shareholder Letter

"There seems to be some perverse human characteristic that likes to make easy things difficult." - Warren Buffett in the Superinvestors of Graham-and-Doddsville

The easy to confirm fact that shares of businesses with great brands and strong distribution have produced such attractive long run returns should be at least noteworthy and, for those curious, deserving of further investigation.**

Those producing the stuff typically found in a cupboard, refrigerator, and medicine cabinet have performed very well (with less risk I think it is safe to say when bought at an attractive valuation) long-term compared to alternatives because they have historically had favorable economics (attractive return on capital).

They've generally had and the best are likely to continue having difficult to disrupt durable competitive advantages.

Has something fundamentally changed their long-term core economics? If not, intrinsic business value should still increase at a satisfactory or better rate over time. A bit boring, maybe, but potentially attractive returns in the long run nonetheless.

My point, in part, is that there's a cost to complexity. When a relatively simple (not easy) approach is likely to produce results similar to (or better than) the more complex one, it's the more straightforward one that is preferable.

Now, it's true that a bunch of investors would do better relying on the skills of a capable money manager (as long as the fees are reasonably low and their own behavior doesn't get in the way of long-term performance). There are certainly some very talented money managers out there. The problem is that too many individual investors do not actually benefit from the expertise. Some of this comes down to investor behavior as pointed out in DALBAR's QAIB, but part of the problem is it's just not that easy to figure out which funds are likely to provide attractive risk-adjusted returns going forward.

Also, professional money managers certainly do, on average, underperform the S&P 500 index over the long haul. According to Vanguard founder John Bogle, from 1984 to 2002 the average stock mutual fund delivered a 9.3% annual return compared to the S&P 500's return of 12.2% a year.

"The reason for that lag is not very complicated: As the trained, experienced investment professionals employed by the industry's managers compete with one another to pick the best stocks, their results average out. Thus, the average mutual fund should earn the market's return—before costs. Since all-in fund costs can be estimated at something like 3% per year, the annual lag of 2.9% in after-cost return seems simply to confirm that eminently reasonable hypothesis." - John Bogle

It gets worse. During that same period the average fund investor, according to DALBAR, earned just 2.6% a year.
(Again, the average fund investor underperformance is largely due to ill-timed buy/sell decisions and fund selection. In other words, a timing penalty and a selection penalty. Bogle adds why he thinks the DALBAR study might actually overstate the annual returns. See his explanation under the Is the DALBAR Study Accurate? section for more details.)

So the sub-par returns were a combination of both fund performance and investor behavior. Also, it's not just that the average mutual fund does poorly compared to a broad-based index. It's quite a bit worse than that. Bogle wrote the following back in 2007:

"The percentage of managers outperformed by the broad market index is, well, time-dependent. On a given day, it's likely about 55%; over a year maybe 60-65%, over a decade perhaps 75-80%, and over 50 years...well, there's no data (yet!) on that!

But the probability statistics suggest that over a 50-year period, some 98% of managers will lose to the market index."

There's a good chart in Bogle's "Little Book" (page 124) that covers this.

Even if the probabilities are somewhat better than what Bogle suggests, those numbers are pretty daunting to say the least. Not seriously considering the implications in the context of one's own investing approach seems unwise. Here's what Jack Meyer, who managed the endowment, pension, and other assets as President and CEO of the Harvard Management Company from 1990 to 2005, had to say:

"Most people think they can find managers who can outperform, but most people are wrong. I will say that 85 percent to 90 percent of managers fail to match their benchmarks. Because managers have fees and incur transaction costs, you know that in the aggregate they are deleting value."

I do find it interesting that there are many professional money managers and traders (some of them frequently appearing on various business news media outlets) recommending various, sometimes rather complex, investing and trading strategies.

It's easy to imagine and expect with all the expertise on display that quite a few of them must seriously outperform. In particular, some might reasonably expect them to outperform a participant who just buys -- at a reasonable price -- and holds long-term the stocks of companies that make the stuff found in a typical cupboard, refrigerator, and medicine cabinet.
(Well, at least those participants who understand business economics, are able to identify sustainable competitive advantages, have a price versus value discipline, while controlling their emotions during inevitable market fluctuations. Not complicated but, based upon investor behavioral patterns revealed in studies, apparently not easy for many to accomplish either.)

Yet, the verifiable evidence at least suggests that many pros do not, over a long time horizon, beat high quality stocks (or the market as a whole) bought when prices are reasonable or better. Also, for those experts that do outperform, there's just no easy way to separate the future fund "winners" from the mediocre (or worse).

It's possible, I suppose, that there are many participants employing various highly "sophisticated" investing/trading strategies who do actually outperform but just happen to be those that cannot be easily verified via SEC filings or confirmed by studies like the above.

Count me as skeptical of this based upon the evidence.

By the way, there's a long list of pros who approach the business using sound investing principles and a number outperform their benchmark.

I don't think the job of a money manager is an easy one. First, they all have to overcome those fees and transaction costs to outperform. In addition, more than a few highly active professional managers ignore the wisdom of Newton's 4th law or are forced to focus on near-term results (in order to keep assets under management stable and, well, keep their jobs) possibly to the detriment of long-term mutual fund investors. Some of this comes down to what has become a hyperactive, casino-oriented, trading culture that now permeates the capital markets. Too many seem to dismiss (or ignore) the merits of what Warren Buffett and Charlie Munger have been saying and doing for a very long time (their ~ 20%/year annualized returns over five decades is no accident). In my view, no small number of professional money managers (and academics) still pick and choose what they like about the Berkshire approach while conveniently ignoring (or inconveniently if you're an investor in a fund) important aspects of their investing principles.

Attractive returns can be achieved (though, as Bogle rightly points out, aren't likely to be achieved by most) by just paying a fair price for 5-10 good businesses and holding them for a very long time. At least that is the case for those who are comfortable with, and capable of, picking individual marketable stocks. It's a simple approach but that doesn't make it an easy one. For some, even more diversification may be necessary but consider this:

"I have more than skepticism regarding the orthodox view that huge diversification is a must for those wise enough so that indexation is not the logical mode for equity investment. I think the orthodox view is grossly mistaken." -Charlie Munger in a 1998 Speech to the Foundation Financial Officers Group

The quote at the beginning of this post makes it pretty clear that Buffett holds a similar view. For those with a long enough investing horizon but lack the background to effectively pick individual securities, something like an index fund, traded minimally, makes a whole lot of sense.

John Bogle has long been a proponent of passive investing over more active styles. He has been providing lots of very wise advice along these lines to investors for a very long time. Too few pay attention to it.***

Otherwise, when considering stocks, the hard part is not necessarily figuring out what to buy. The difficulty comes down to whether the individual has the discipline, temperament, and patience to buy -- and hold long-term -- with enough margin of safety what they understand while ignoring the daily price fluctuations. In fact, since bear markets are inevitable, ideally it's best to be buying/accumulating more shares of high quality businesses -- what the investor knows the best and likes the most -- whenever the news is rather terrible. It's easy to make the mistake of overestimating one's own ability to do this.

No matter what it is best to avoid an excessive amount of trading activity. The trades create not only frictional costs but also more chances to make costly mistakes.
(There's a tendency -- due to overconfidence and overestimation of abilities -- to overweight the upside possibilities of a trading decision and underweight the downside. The net result can be costly.)

So buying shares of good businesses at a discount doesn't assure long-term outperformance. Certainly not. It's just that the possibility of achieving good risk-adjusted results improves over the long haul if:

1) an investor knows how to figure out, within a range, what a good business is worth, and

2) if that investor routinely pays a nice discount to per share value for it.

It's the partial long-term ownership of high quality businesses, compounding intrinsically in value over time, while avoiding meaningful mistakes. Mistake avoidance, especially those that result in permanent loss of capital, is key to the success that comes from this style of investing.

What's more doable?

A) Correctly picking, buying, and holding the actively managed mutual funds that will be the long-term top performers among the thousands of funds.
(Finding needles in a haystack.)

B) Buying shares of 5-10 (or, for those who prefer or require more diversification, maybe somewhat more) of the great business franchises -- those that are understood well when available at a discount to value -- then holding them for 20 years and, ideally, even longer. The returns for investors come via per share intrinsic value growth of the businesses not trying to own the right stocks or sectors at just the right time. In other words, no unusual trading skills (in fact, minimal trading is a must) or capacity to time the market is required.
(Identifying the highest quality businesses, those with modest debt and great brands/strong distribution, seems more akin to finding needles in a stack of needles. Well, at least for an investor who feels comfortable enough in their ability to understand business economics. Otherwise, identifying the strongest producers of small-ticket consumer goods is not exactly tough to do. Now, having the patience and discipline that's required to only buy shares in meaningful amounts when they're selling at a nice discount can be very challenging.)

C) Accumulating the shares of an index fund that has very low expenses steadily over time.

Whether A, B, or C makes more sense comes down to individuals capabilities and circumstances. No one should be buying stocks if it's not in their own comfort zone. Investing effectively mostly involves realistically assessing one's own limits and staying well within those limits. Based upon the evidence, it seems quite likely that C makes sense for a whole bunch of investors.

There are many fine mutual funds and talented professional managers out there. Yet, it can be far from easy to differentiate between who'll deliver above average and subpar results prospectively.

The long-term strengths and merits of a company like Coca-Cola against its peers seems to me, by comparison, relatively straightforward. Well, at the very least, it happens to be in my own investing comfort zone even if it doesn't necessarily make sense otherwise. Bogle's advice ought to get heavy consideration before venturing into individual stocks. It certainly influences my approach though the fact that I'm buying individual stocks would seem to suggest that's not the case. Here's how it fits in rather nicely. My own view is that index funds, traded minimally, outperform mostly because 1) frictional costs are kept low, and 2) the driver of returns is the long run per share intrinsic value increases of the many businesses in the index.

Basically, investors are kept from being their own worst enemy and incurring excessive frictional costs.

Well, it's possible to also minimize frictional costs in a much more concentrated equity portfolio while similarly allowing the per share intrinsic business value, as it increases, to be the primary driver of returns. The main downside, at least in the view of some, is increased risk due to lack of diversification but, once again:

"We believe that a policy of portfolio concentration may well decrease risk if it raises, as it should, both the intensity with which an investor thinks about a business and the comfort-level he must feel with its economic characteristics before buying into it." - Warren Buffett in the 1993 Berkshire Hathaway Shareholder Letter

So I think the approach has more in common with what Bogle has often recommended than it may seem to at first glance. An index fund isn't really the only way to invest in a relatively passive manner (passive trading-wise not homework-wise). The diversification debate is a legitimate one, but it's possible to own a concentrated, though otherwise relatively passively managed, equity portfolio. The approach has similar benefits to indexation -- low frictional costs, fewer investor mistakes, returns primarily from increases to intrinsic business value over a very long time horizon. Well, at least that's the case for those who understand business economics and can identify durable advantages while consistently buying shares at a discount to conservatively estimated value. It's a passive approach because, while there's lots of work that goes into understanding and valuing the businesses themselves, there's little in the way of trading activity.

No matter what the right long-term investment vehicle(s) might be (it's necessarily different for each individual) the key is always to avoid the temptation to trade excessively.

Based upon experience, I don't expect to convince many market participants of this.

Adam

Long positions in BRKb, PG, PEP, KO, PM, and DEO

Related posts:
Staples vs Cyclicals
Best and Worst Performing DJIA Stock
Defensive Stocks?

* A 16 percent annualized total returns (incl. dividends) over 20 years will turn a $ 10,000 investment into just under $ 200,000. Each of these stocks produced returns, give or take, in that ballpark. Now, it's not as if anything like these kind of returns will occur over the next twenty years. For lots of reasons that seems extremely unlikely. The very best funds will almost certainly do better. It's just that the best of these types of businesses (those with durable and attractive returns on capital) have a good chance of doing very well over a 20-year time frame at comparably low risk, as long as trading activity is minimized, and they're bought at reasonable valuations. As mentioned above, my preference happens to be PM and DEO but think highly of, even if to a lesser extent, the other stocks I've established long positions in (as noted above) when bought at the right price. PM and DEO do lack a convenient way to check their 20-year historical performance since they've not been trading as separate marketable stocks long enough. That comparative lack of historical performance doesn't negate their durable advantages, sound core business economics, and generally favorable long-term prospects. It's worth noting that PM, DEO, and PEP are each part of the Six Stock Portfolio.
** These higher quality businesses don't need to always outperform (and likely will not) the top 20 funds over a twenty year period to be worthwhile. Even if shares of the higher quality businesses did not outperform over the long haul going forward (and they may not, of course), the sheer simplicity of the approach compared to alternatives needs to be considered. So does the reduced likelihood of permanent capital loss and more narrow range of outcomes. In fact, if the quality franchises produced merely market returns they'd still win in my book. The reason is that, if bought well, the same return will have been arguably achieved at less risk of permanent capital loss (not temporary paper losses). Now, anyone buying the higher quality stocks expecting them to outperform during the next bull market will likely be disappointed. Look elsewhere for exciting price action. That is, in part, how they have earned the reputation of being defensive. Yet, this reputation is verifiably incorrect when you look at the historic returns of these stocks over the longer haul (at least a business cycle or two). Otherwise, the fact that they've delivered attractive risk-adjusted returns, rather passively, seems like more than just merely an intriguing aberration. Here we have a case where unusual trading skills, market timing acumen, or awe-inspiring foresight is not required. In fact, quite the opposite. It's simply buying, when cheap, shares of enterprises that make the great small-ticket consumer products -- especially those with the strongest brands -- and avoiding the temptation to trade excessively. In particular, the companies with scale, dominant distribution, and, of course, sound financial health. Are the right analytical skills and other capabilities required to do this effectively? Of course. Yet, beyond that, it's mostly knowing when to utilize a simple but useful insight if it presents itself. Over much shorter time horizons -- five years or less -- just about anything can happen as far as relative performance goes. It's always useful to extend the time horizon to reduce the mistakes that come from reacting to shorter term noise. My definition of short-term here might seem more long-term by the standards of many market participants these days.
*** Index funds beat the vast majority of active money managers. Is it easy to imagine someone with modest medical training performing at the level of a highly skilled surgeon? Of course not. Yet the equivalent seems possible in the context of investing. Are extraordinary returns, quickly achieved, possible this way? No, not really, but investing comes down to judging what will produce the most attractive relative risk-adjusted returns. These approaches (buying shares of high quality businesses held long-term or indexation) will never produce "lottery tickets" but it sure beats the typical experience of investors as noted by the QAIB and other studies. So no fast money here. Besides, it's not like lottery tickets (and certain more aggressive investing strategies) don't have asymmetric risk of permanent capital loss compared to possible gains. During shorter time horizons it's more likely to find individual funds (And, of course, many individual stocks but the big winners often reside near the big losers.) that outperform index funds or shares of the higher quality franchises. Some may try to jump in and out of investments (whatever happens to be "hot") at just the right time to enhance returns. I don't doubt some even succeed with such an approach but, at least based upon the available evidence, it's an idea that mostly seems good in theory, less so in practice.
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