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Author: stevivette Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 212542  
Subject: S&P 500 Index Risk Date: 3/18/2002 4:03 AM
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The Fool and other media constantly promote the fact that something like 70 to 90% of all managed mutual funds under-perform the S&P 500 Index. If one considers managed mutual funds with more than 10yrs operating history, and includes expenses, I'm sure the number that beat the index is far less than 10%. However, rather than dismiss this as a reason to Index, why not investigate who has beaten the Index for long periods of time, expenses included?

I'm an avid reader of financial literature, and know my way through a balance sheet, cash flow statement and income statement. I think my psychology is also adequate for equity investing. However, regardless of how much effort I put in, I have come to the conclusion that my investing insight and skills will never be nearly as successful as the most talented people in the field. Because I have about one-millionth the assets of Buffet and Munger, does that give me enough edge so that there's a good probability that I can beat them at their game? If Michael Jordon gets the flu and sprains his ankle, does that mean I now have a good chance to beat him one on one? For myself, the answer to both is “no”. That doesn't mean I've given up on stock picking, or playing basketball. It just means I'm aware of my limitations, and play those games accordingly.

I've believed in the index philosophy for the better part of the last 6yrs, with roughly 50% of my savings in an S&P 500 Index Fund. However, mid last year I changed my tune and moved this money out of the index. The reason is that I have read too many logical arguments that support the extent to which the S&P Index is overvalued. Perhaps the best assessment of this that I have seen was in the July 31, 2000 edition of Outstanding Investor's Digest. Jeremy Grantham, of Grantham Mayo Van Otterloo, gave a presentation that in OID is titled “Bubbles have always given back everything. There have been no exceptions – none.” This article supplies excellent data that illustrated the overvaluation of the market in 2000. However, most of the parameters that Grantham presented in 2000 still indicate significant overvaluation today. For OID members, this article can be downloaded from the OID website (adobe acrobat file), otherwise, I'm guessing it can be obtained from Grantham Mayo Van Otterloo's website.

One parameter for estimating the “value” of the S&P 500 Index is P/E. Unless put in the proper context, any given Price/Earnings estimate can be very misleading for an individual company. However, for the market as a whole, I think P/E holds more water. The 30yr average P/E is 14. Currently it's in the mid 20's. Just with this information alone, one has to propose that one of the following three generalities applies to the P/E of the S&P 500:
1. The average P/E of the S&P 500 will not return to historical levels. Perhaps history will not repeat itself. There are more people in the market, so perhaps that has permanently driven up the demand for, and value of, equities. The weighting of the S&P 500 is different, more towards technology, and perhaps this could result in a permanent increase in P/E.
2. Earnings as a whole will start to increase faster than price, and Buffett's predictions for growth (over the next decade) are too low. Of course this is a possibility, and there have been periods in the past where earnings have grown faster than price for long periods of time. However, in our trigger-happy society, it's hard for me to imagine a future where earnings rise faster than prices for long periods of time. But it's possible.
3. Prices will come down faster than earnings. Buffett has estimated relatively slow growth for the next decade or so. This, combined with the fact that the market is still historically overvalued, does not make a good case for S&P 500 Indexing over the next decade.

I don't know which of these scenarios will arise. However, in my mind, the odds are not strongly in favor of the S&P 500 Index resulting in a reasonable rate of return for the next many years. If you consider long term to be 20-30 years, and you don't care what happens for the next 10, then perhaps you won't be disappointed. And perhaps case 1 or 2 turns out to be reality. But for me, the odds are not good enough.

My personal solution was/is to look for those few fund managers that have beaten the S&P 500 Index over periods of 10 years or more. Instead of saying 90% of managed funds can't beat the index and throwing in the towel, I'm choosing to look at those who have beaten the index. The list is much smaller than I thought it would be. Perhaps others can add to this list (or subtract from it).

I narrowed down the list by looking for managed mutual funds that meet the following criteria:
n Funds that have beaten the S&P 500 Index for at least 10 years (average return and including fund expenses). I don't think there is any validity to looking at less than 10yr criteria, since I am looking for management that has a good chance to be successful with my long-term savings. I must note that my analysis does not give enough emphasis to turn-over (generating capital gains). Most of my mutual fund holdings are in non-taxable accounts, so I don't give it enough consideration here. Obviously a high turnover in a taxable account will result in diminished results.
n Funds that have a total expense ratio less than 1.1%. There are several funds that have beaten the index with higher fees attached. But I think the odds of their future success are significantly diminished with these higher charges. I used 1.1% to let a couple of favorites squeak onto the list.
n Funds that are still open to new investors.
n Funds that have management with impeccable credentials, have large holdings in their own funds, and write thought provoking and honest reports. This is a subjective requirement, but if I can't be kept up to date and feel that management is logical and honest, then I'm not interested. Berkshire Hathaway's annual report is the standard by which I estimate this subjective measure. Several fund managers do an excellent job, and since less mimicked that Buffett, are also are more willing to discuss individual stocks and segments of the market.
n Simplicity. If a manager is involved in more than a few funds, or a fund company has more than a few funds to choose from, I crossed them off. If mutual fund picking becomes as time consuming or difficult as individual equity analysis, then what's the point? And if a fund manager can't focus, then what is his strategy?
n Philosophy that I agree with. I did not run into any funds that met the above criteria seemingly by luck, however, I would not have included them if I had. Say a fund that had a couple of years of unbelievable growth, and was off-set by 90% years of terrible performance. I actually expected to find something like this, but never did. Every fund I found considers “price” an extremely important ingredient in equity trading. Although the way value is calculated and used varies dramatically between some of the funds below. Perhaps there are successful funds that don't give much consideration to stock price, however, I have not found a single one.

The mutual funds I came up with are:

1. Dodge & Cox Stock Fund –
This group has been around since the 1930's, with this particular fund available since the 1960's. They have beaten the index for the last 20yrs and for the last 10yrs. Their expenses and turnover are the lowest in the managed mutual fund business. The total expense ratio is only 0.54%. And for what it's worth, they have not had a single year of negative returns for at least the past 10 years.

Some additional information about Dodge & Cox is that the Dodge & Cox Income Fund is also likely the best in it's sector. FPA New Income gets a lot of press in OID, but in actuality, this income fund is a rip-off with its huge sales charge. For generating income, or for medium term (1-5yr) savings, I don't know if anyone can beat the Dodge & Cox Income Fund (PIMCO has some funds that come in a close second). It's got the best record I can find, and does it with lower risk (better quality bonds) than most income funds. Dodge & Cox has also just started an international fund with most of the same members of its Stock Fund management team, and as typical, keeps expenses the lowest in the business (0.9% for their international fund).

2. Longleaf Partners Fund –
Great historical results, low fees and management of integrity. They are the biggest holders of their own funds. What I like most about these guys (setting them apart from the others on this list) is they maintain a focused fund of something less than 30 stocks.

Additional info is that they have also just started an international fund. It's focused as is their Partners Fund, but the total expenses are quite high (1.75%), although this is below the average for international funds.

3. Oakmark Fund –
Great historical results, low fees and management of integrity. I don't know if it's good or bad, but management is not shy about discussing their favorite stocks, and management gets a lot of press.

4. Weitz Value Fund –
Similar comments to Oakmark, although they don't get quite as much press. Management has an uncommon way to value stocks. Downside is that it takes $25K to open an account.

5. Third Avenue Fund –
Similar comments to Weitz. My favorite “letter to shareholders” of any managed mutual fund. Also just started an international fund. It's interesting to me that three of the very best in the business have just recently started international funds (although have always had international holdings in their original funds).

That's it. I only found 5 funds!

Now here's several other funds of interest that didn't fully meet the above criteria, but I think are worth keeping up with:

Tweedy Browne Funds – They are slightly above the expense limit I set above, and their 10yr performance is significantly below the index. However, this team is probably the most respected of all managed funds and offers a plethora of great reading. Their global fund expenses are well below the typical international fund and their turnover is very low compared to other funds. It's my opinion that the odds are high that their philosophy will outperform the market over the next decade, including expenses. They also have some good discussions regarding the current valuation of the S&P 500.

Aegis Small Cap – Didn't make my cut because of its short operating history and 1.5% total expenses, however this expense ratio is very low for a small cap fund. They put their money where their mouth is and their managers have been in the game a long time and have a logical and clear investment philosophy.

Fairholme Fund – Didn't make the cut because of its short operating history, however the fund manager has an excellent reputation. The philosophy here is to have a concentrated portfolio of good quality stocks purchased at good prices. OID recently published an interview with the manager.

Legg Mason Value Trust – Didn't make the cut due to expenses, although they are not exceptionally bad at 1.65%. Although they've bested the S&P every year for the past 10yrs, it's not clear to me that they have done it by a significant margin after considering expenses. It's also a gargantuan fund (~$17 billion in assets). But for me, it's a great fund to follow for philosophies and ideas.

Olstein Financial Alert – Short operating history and terribly high expenses of 2.1%. I will never fully trust a fund manager that has significant 12b-1 fees. However, the ideas and philosophies of the manager are very interesting to me.

Gabelli – Has interesting ideas and material to read. However, there are so many funds and Gabelli appears spread so thin, that I don't have much interest in trying to figure out what fund might be worthwhile. Also the fees for most of his funds are ridiculous. But it's definitely worth it to check the website and read his perspectives and ideas.

Templeton Funds – Similar comments to Gabelli.

Sequoia Fund – One of the best records of all time, but closed to new investors. However, the annual reports still provide great insight into the mind of a great investor.


My point is not to promote managed mutual funds. In fact, I have a profound hatred of mutual funds in general. I'm simply trying to point out a few “diamonds in the rough”. I'm only looking for the best way to invest my money for the long term, considering the outlook for about the next 10 years, and considering my abilities. For me, liberal use of the information provided by the most successful in the business is the most logical first step. And in some cases, where everything falls into place, I have invested a significant portion of my savings in a few of the funds mentioned above. My personal opinion is that someone who wants to “invest with ease” is taking a relatively big risk in owning only the S&P 500 Index over the next decade. Perhaps this can be construed as trying to time the market, however, evaluating what has the best odds of keeping several points ahead of inflation over the next decade is not the same as trying to guess what some particular company is going to do next quarter. It just seems obvious to me that the odds are somewhat high that investing in the S&P 500 Index is going to be a poor way to grow capital over the next decade. If I'm wrong, I don't think the downside of my decision (to move S&P Index fund holdings into a few of the best managed funds) could be too terrible.

I've lurked these boards for the past 4 yrs, but have never taken the time to contribute until now (always the taker and never the giver). Luckily, there are enough people out there with more commitment and dedication. Any comments or criticisms are welcome.

-- Steve
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