WHAT CAN SMARTMONEY
tell you about mutual funds that you don't already know? After all, the fund industry now manages about $10 trillion in assets, and knowledgeable investors in other words, you have learned what to look for: high returns, experienced managers and reasonable fees. But these days there's a huge potential pitfall that even savvy shareholders can easily miss invisible costs.
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New research suggests that Americans may be paying a lot more than they realize for the privilege of owning shares in a mutual fund. Fund fees, of course, have gotten plenty of attention in recent years, spurring even casual investors to keep an eye on what they're paying. But when funds trade excessively, or make moves that trigger capital-gains taxes, the investor takes another hit. Indeed, costs like these can siphon away thousands of dollars in returns over time and most of them never show up on fund statements.
According to a new, unpublished study, trading costs at the typical diversified U.S. stock fund add up to 1 to 1.25% of assets. "The real question is whether the expenditures lead to better returns," says Gregory Kadlec, a professor at Pamplin College of Business at Virginia Tech and one of the study's authors. The answer? Generally, no. On average, funds recoup in gains only about half of what they spend on trades, says Kadlec: "The other half is dead weight on performance."
Research based on data from fund tracker Morningstar suggests one way that the weight can get heavy. Over the past one, three, five and 10 years, funds that ranked in the lowest 25% in turnover, a rough measure of how often they trade, have earned two to three percentage points more on an annual basis than those in the highest quartile. Brokerage commissions on transactions are one factor that drives up costs. Additionally, when a fund dumps or scoops up a big block of shares, its own transactions can also move the stock price. That phenomenon, known as market impact, can make the trades less advantageous for shareholders. And a fund's capital gains can be taxed at up to 35%. Granted, some funds that trade furiously still generate stellar returns, but they're more the exception that proves the rule.
As we searched for the top funds, we discovered that many of the managers who trade best trade least. Their funds are the focus of this year's guide. To track down our top 35, we started with funds from seven categories, each with great records and promising outlooks. Then we factored in the difference between returns before and after taxes. We also looked for funds that minimize trading and tax costs by holding down turnover the percentage of the portfolio that gets replaced each year. Finally, we eliminated funds whose combination of expense ratios and 12b-1 marketing fees was too high. Most of our picks have no 12b-1 charges at all, so you may pay a transaction fee if you buy them from fund supermarkets like those at Fidelity or Charles Schwab. Buy them directly from the fund companies and you'll avoid that fee one more hidden cost you're leaving behind.
The Best of...
Five-Year Return: +36%
Bob Smith has been running the T. Rowe Price Growth Stock fund for close to 10 years, but don't think the job is getting any easier. "There is a lot more noise" than there was a decade ago, he says, meaning that when a company suffers a business setback or generates a scandal, the media and Internet echo chambers magnify the impact on the share price. Under those circumstances, says Smith, "it's more tempting to sell." It's a difficult climate for a manager whose primary goal is to find, and stick with, companies that will grow at a faster rate than the overall market over the next three to five years.
Still, if it's tougher to stand his ground today, Smith isn't caving. A case in point is UnitedHealth Group, one of his top holdings. Shares of the health insurer have tanked amid allegations that it improperly backdated options. Sentiment soured further when Democratic gains in the 2006 elections gave investors jitters about the industry in general. Smith isn't happy with the idea that management may have acted unethically, but he believes the business is still good. As other managers dumped the stock, Smith happily scooped up more shares. He estimates that UnitedHealth can still boost earnings 15% a year through increased enrollment and stock buybacks. That said, the stock still fell about 20% last year. "Yes, it's a terrible stock now," Smith says, "but it could be the best long-term holding I've ever had."
Smith's buy-and-hold discipline has worked well so far. The fund has delivered a 9% annualized return for the past decade, beating 92% of its large-cap growth competitors. And the long-term strategy helps keep the tax impact to a minimum, says Smith, who should know he has a hefty chunk of his own savings in the fund.
Seeing the bigger picture also helps Smith explain other changes in the market. The line between "growth" and "value" investing has become increasingly fluid, he says: "Growth investors are trying to find value in the future. Value guys want what is currently mispriced in the marketplace." Today he sees the strategies converging for some stocks, particularly for big-cap companies with different businesses under one roof. General Electric, which is expected to produce double-digit earnings growth in the next few years, is now Smith's top holding. It's also one of the biggest stakes in T. Rowe's Value fund, one of our other top picks which just confirms Smith's theory.
Five-Year Return: +59%
Bucking convention is second nature to John Linehan. In 1998, when his Stanford b-school classmates flocked to high-paying jobs in booming Silicon Valley, the Baltimore native took a job as an analyst covering stalwarts of the Old Economy: paper and forest products. "They all looked at me like I was crazy," he says with a laugh. "I loved it."
Such contrarian impulses have served him well at the helm of the T. Rowe Price Value fund. On his first day as manager in March 2003, Linehan had planned to make a stock pick that reflected sound analysis and thorough research. Instead, he zeroed in on a tumbling Philip Morris, a blue chip facing a $10 billion liability verdict and possible bankruptcy and bought it before lunchtime. He later added other beaten-down companies like Merck, Tyco and insurance broker Marsh & McLennan. While Linehan still holds many stocks he inherited from Brian Rogers, the longtime manager who's now T. Rowe Price's chief investment officer, he thinks deep value's run is almost over. So he's built big stakes "on the growthier edge of value," where he sees historically cheap prices on stocks with double-digit earnings-growth potential. Two traditional growth stocks, Microsoft and GE, are now his biggest holdings.
Swimming upstream has paid off. In the past three years, the fund has returned an average 15% per year, better than 81% of the large-cap-value offerings. But he's not just looking for stocks in dire straits. He wants to see a good company that's cheap compared with its sector and the market as a whole. That gives him the flexibility to hold stocks even if appreciation makes them look expensive by strict valuation standards. It also keeps turnover low; he holds stocks more than three times longer than his peers. The result is a remarkably tax-efficient fund. Granted, tax efficiency became an unexpected stumbling block for Linehan in 2005. "I did several trades to harvest losses for taxes, and everything I sold went up in the fourth quarter," he says. "We'll try not to do that again."
Five-Year Return: +106%
David Decker has been thinking about taxes lately. He's sunk all of his money in the fund he manages, Janus Contrarian, and for the first time in several years, the fund just paid out a sizable dividend. "We took some gains [last] year, and I think it was the right thing to do," Decker says. After all, the move freed him to buy companies with more upside, and incurring some capital gains is often better than the alternative holding on to stocks that have peaked.
More important, last year's tax hit is the result of a handful of prescient investments; the fund returned 23% through early December of 2006. As the fund's name suggests, Decker is searching for overlooked companies, and when he finds them, he tries to evaluate what the enterprise is worth. If it's significantly more than what the share price suggests, it's a good sign he's found a stock he can hold for three to five years. Take, for example, Apple Computer. Decker bought in 2003, when the stock was trading at $7, a price that barely captured the cash on Apple's books and its Cupertino real estate. The stock didn't look conventionally cheap, Decker notes, because the company's earnings were weak, and the market ignored it. Three years and one iPod revolution later, Decker sold his position in the mid-$70s.
Given that Decker is running his own nest egg, he has extra incentive to look for an array of investments. He can invest in companies of all sizes, though with $4 billion to manage, he tries to avoid the very small. He focuses on different measures of valuation for each company, with startling results: Media conglomerate Liberty Global and Florida real estate giant St. Joe each make up about 6% of the portfolio, but Liberty Global trades at a modest 13 times earnings, while St. Joe has a P/E of 78. About 40% of the fund is invested overseas; an Indian energy concern called Reliance Industries, a Singapore REIT and Cemex, the Mexican cement company, round out Decker's top 10. As his peers went gaga for China, Decker looked to India, where he now owns 11 companies positioned to profit as the country improves its infrastructure. Big bets like this don't always pay off. When emerging-market stocks fell sharply in May, the fund took a hit. But Decker, a Warren Buffett acolyte, reminded shareholders that he'd rather have "a lumpy 15% return than a smooth 10%."
Five-Year Return: +74%
Back in the 1960s when Richard Aster was studying economics at the University of California in Santa Barbara, he was fascinated by a group of popular new restaurants. They were unmistakable. No matter where he and his buddies went, the eateries all looked exactly the same. Aster sent away for an annual report, studied it and eventually bought some shares in the new chain: McDonald's. "It was the first stock I ever owned," says Aster, who has been running the Meridian Growth fund since 1984. "I sold way too soon."
Nonetheless, McDonald's taught Aster that investors with a sharp eye for midsize businesses can see their portfolios grow as the companies do. At Meridian, he targets firms with market values between $500 million and $2 billion but won't necessarily sell a winner if it heads toward large-cap territory, as long as it's got earnings growth in the double digits. Aster typically holds stocks nearly four times longer than the average midcap growth fund. Not only does he avoid brokerage commissions, he also doesn't read brokers' research. "We try to do it ourselves from the ground up," Aster says. At any given time, he and his team of five analysts monitor 100 to 200 potential candidates. In addition to strong growth and reasonable prices, Aster looks for market leaders in thriving industries. A prime example is top holding American Tower, one of the largest operators of wireless communication towers in the U.S., Brazil and Mexico.
Aster's independence and prudence have helped the fund avoid speculative bubbles like the Internet boom and bust and build an impressive long-term record. With annualized returns of 12% and 13% over the past five and 10 years, respectively, the fund is beating 89% of its peers. Meridian has only nine employees, and the lean structure has enabled the fund to charge an expense ratio of only 0.85%, compared with 1.57% for the average midcap fund. Aster has more than $1 million of his own money invested in the fund, so he feels the tax bite along with the rest of the shareholders when the fund pays distributions like the larger-than-usual one it made in 2006. "You have to pay it sometime," he says. But Aster notes that more than 95% of the capital gains the fund has taken have been long term, which means a lower tax bill.
Five-Year Return: +87%
Jason Votruba and Adrianne Valkar talk stocks all the time. But when it comes time to buy or sell, the division of labor is clear. Votruba buys. Valkar sells.
Okay, it's not quite that simple, but it's close. That separation of responsibility is integral to the success of UMB Scout Small Cap. "When you're buying, you want someone who's somewhat fearless, but smart enough to make good decisions," says Scout Funds Chief Investment Officer William Greiner. "Selling is a little different, because you're either admitting a mistake or you're capitalizing on a winner. And that can be hard if you fell in love with the stock in the first place." The managers boast that their approach takes the emotion out of investing. Votruba, who was trained as a small-cap analyst and specialized in takeovers, looks for companies with lots of cash on the books, strong earnings potential and minimal debt. But the team also relies on a layer of technical analysis looking for trends in the movement of a stock's price and sifting good exit points out of the data is Valkar's specialty. Problems in a company's fundamentals, she says, often show up in the charts long before they're made public in earnings reports.
In the past three years, this growth fund has returned an average 15.5% annually, better than 92% of its peers. Buy-and-hold approaches are rare among pure small-cap funds because good holdings often either get acquired or grow into the midcap range. But Scout typically holds its stocks a little more than a year longer than the average for the category. The managers restrict their investments to bona fide small companies and use their turnover for tax advantages. "We don't wait for big losses," says Valkar. "We sell our losers quickly, and a by-product of that is tax-efficiency."
In the spring of 2006, the managers stopped seeing buying opportunities and let cash build to almost 20% of the portfolio, weighing down short-term returns. But Votruba started finding attractive names in the fall, especially among medical technology and information-technology companies. One recent top holding, FileNet, was acquired last year by IBM, generating a nice payoff for the fund. We were mildly concerned to learn that longtime manager Dave Bagby left the portfolio last September. But for the past three years, Greiner says, Valkar and Votruba have been running the portfolio under Bagby's direction, and there are no plans to change course.
Five-Year Return: +159%
During a free weekend on a recent trip to London, Bernard Horn hopped on the Tube and went house hunting. The 52-year-old manager of Polaris Global Value chatted up recent buyers and sales agents, toured model homes and inquired about potential rental values. He wasn't actually looking for a house (and his Boston accent pegged him as an unlikely buyer), but he was checking out an investment: one of his longtime holdings, British home builder Belway. Investing, after all, "is like buying a house," he says. "If you want to find a great property that's being sold way under market, you know you have to look at everything and make very shrewd comparisons. It's not rocket science, but it does take a lot of legwork." Before they leave the office, Horn's investment team use technical screens to winnow the field. They're looking for the 75 most undervalued companies, regardless of size, country or sector. Right now 37% of the portfolio is invested in U.S. stocks slightly below those stocks' weight in the global market.
Horn looks for high free cash flow, good management and strong financials. And because he likes the flexibility to invest in tiny companies as well as big ones, he says he'll stop taking new money once his total assets under management hit $5 billion. (Good news for investors who haven't climbed aboard yet: That's twice what they are now.) Lately, Japanese companies have looked attractive, and Horn has invested 13% of the fund in companies that primarily serve Japan's domestic market, including a dairy, a brewery and a regional railroad. Horn believes those picks should balance out the portfolio's big stake in the potentially volatile raw-materials sector.
Returns, meanwhile, have been stellar: an average of 21% per year since 2001, tops among global funds. Low turnover keeps taxes to a minimum. A $1,000 investment would have grown to $2,590 over the past five years while losing just $40 to taxes. And Horn, who has parked his own savings in Polaris Global, has steadily reduced expenses since inception; they're now at 1.30%. "I don't want to pay higher fees either," he says.
Five-Year Return: +154%
Call it the time-capsule approach to investing. Every time the eight comanagers of the Dodge & Cox International Stock fund buy or sell a stock which they do by committee they imagine the new portfolio will get locked away in a vault for the next five years. If they think they'll be pleasantly surprised when they open the door, they make the change. It's a high bar: On average, they add just six new stocks each year.
"We're really, really patient," says comanager Diana Strandberg. "There will be times when our shareholders' patience will be tested, but we want our investors to think long term, too." Actually, investors don't have much to complain about. The fund returned an average of 21% over the past five years, better than 90% of its peers, and the tax consequences were tiny. The commitment to low costs has been part of the firm's philosophy since its 1930 inception; in keeping with that tradition, Dodge & Cox recently cut expenses on International Stock from 0.90% to 0.70, less than half the category average.
In selecting stocks, the committee will look at "anything that's relatively cheap," Strandberg says. They're seeking potential earnings growth and cash flow, especially where other investors have walked away. That led to an overweighting in energy and materials when the fund was first formed in 2001. It later inspired a commitment to a handful of Brazilian companies, which the team bought in 2002 and held on to even as the ascent of populist President Luiz Inacio Lula da Silva and the currency crisis in neighboring Argentina spooked investors. At times like those the team approach pays off, says CEO John Gunn: "When you're whistling through a graveyard, you need someone to hold your damp hand." But if they open their Brazil time capsule today, they'll find that two of their positions are up more than 500%, while a third has more than doubled.
Lately, the management team likes pharma and technology, including consumer electronics Nokia and Matsushita are two of their biggest holdings. Almost a quarter of the portfolio is invested in Japanese companies. And while they're strictly company-by-company stock pickers, they see a theme emerging: Technology will continue to drive progress, and the developing world will continue to drive global growth.