Fees and Mutual Fund Returns
4.8 INFORMATION ON MUTUAL FUNDS
On the other hand, this relationship does not seem stable across different sample peri- ods. Malkiel5uses a larger sample, but a similar methodology (except that he uses one-year instead of two-year investment returns) to examine performance consistency. He finds that while initial-year performance predicts subsequent-year performance in the 1970s (see Table 4.4, Panel B), the pattern of persistence in performance virtually disappears in the 1980s (Panel C).
To summarize, the evidence that performance is consistent from one period to the next is suggestive, but it is inconclusive. In the 1970s, top-half funds in one year were twice as likely in the following year to be in the top half as the bottom half of funds. In the 1980s, the odds that a top-half fund would fall in the top half in the following year were essentially equivalent to those of a coin flip.
Other studies suggest that bad performance is more likely to persist than good perfor- mance. This makes some sense: It is easy to identify fund characteristics that will pre- dictably lead to consistently poor investment performance, notably high expense ratios, and high turnover ratios with associated trading costs. It is far harder to identify the secrets of successful stock picking. (If it were easy, we would all be rich!) Thus the consistency we do observe in fund performance may be due in large part to the poor performers. This sug- gests that the real value of past performance data is to avoid truly poor funds, even if iden- tifying the future top performers is still a daunting task.
objectives and policies in a concise “Statement of Investment Objectives” as well as in lengthy discussions of investment policies and risks. The fund’s investment adviser and its portfolio manager are also described. The prospectus also presents the costs associated with purchasing shares in the fund in a fee table. Sales charges such as front-end and back-end loads as well as annual operating expenses such as management fees and 12b-1 fees are de- tailed in the fee table.
Despite this useful information, there is widespread agreement that until recently most prospectuses have been difficult to read and laden with legalese. In 1999, however, the SEC required firms to prepare easier-to-understand prospectuses using less jargon, simpler sentences, and more charts. The nearby box contains some illustrative changes from two prospectuses that illustrate the scope of the problem the SEC was attempting to address.
Still, even with these improvements, there remains a question as to whether these plain- English prospectuses contain the information an investor should know when selecting a fund. The answer, unfortunately, is that they still do not. The nearby box also contains a discussion of the information one should look for, as well as what tends to be missing, from the usual prospectus.
Mutual-fund investors are about to get shorter and clearer disclosure documents under new rules adopted by the Se- curities and Exchange Commission earlier this week.
But despite all the hoopla surrounding the improve- ments—including a new “profile” prospectus and an eas- ier-to-read full prospectus—there’s still a slew of vital information fund investors don’t get from any disclosure documents, long or short.
Of course, more information isn’t necessarily better.
As it is, investors rarely read fund disclosure documents, such as the prospectus (which funds must provide to prospective investors), the semiannual reports (provided to all fund investors) or the statement of additional in- formation (made available upon request). Buried in each are a few nuggets of useful data; but for the most part, they’re full of legalese and technical terms.
So what should funds be required to disclose that they currently don’t—and won’t have to even after the SEC’s new rules take effect? Here’s a partial list:
Tax-adjusted returns:Under the new rules, both the full prospectus and the fund profile would contain a bar chart of annual returns over the past 10 years, and the fund’s best and worst quarterly returns during that pe- riod. That’s a huge improvement over not long ago when a fund’s raw returns were sometimes nowhere to be found in the prospectus.
But that doesn’t go far enough, according to some in- vestment advisers. Many would like to see funds report returns after taxes—using assumptions about an in- vestor’s tax bracket that would be disclosed in footnotes.
The reason: Many funds make big payouts of dividends and capital gains, forcing investors to fork over a big chunk of their gains to the Internal Revenue Service.
What’s in the fund:If you’re about to put your retire- ment nest egg in a fund, shouldn’t you get to see what’s in it first? The zippy new profile prospectus describes a fund’s investment strategy, as did the old-style prospectus.
But neither gives investors a look at what the fund actu- ally owns. To get the fund’s holdings, you have to have its latest semiannual or annual report. Most people don’t get those documents until after they invest, and even then it can be as much as six months old. Many investment ad- visers think funds should begin reporting their holdings monthly, but so far funds have resisted doing so.
A manager’s stake in a fund: Funds should be re- quired to tell investors whether the fund manager owns any of its shares so investors can see just how confident a manger is in his or her own ability to pick stocks, some investment advisers say. As it stands now, many fund groups don’t even disclose the names and backgrounds of the men and women calling the shots, and instead re- port that their funds are managed by a “team” of individ- uals whose identities they don’t disclose.
A breakdown of fees:Investors will see in the profile prospectus a clearer outline of the expenses incurred by the fund company that manages the portfolio. But there’s no way to tell whether you are picking up the tab for an- other guy’s lunch.
The problem is, some no-load funds impose a so- called 12b-1 marketing fee on all shareholders. But they use the money gathered from the fee to cover the cost of participating in mutual-fund supermarket distribution program. Only some fund shareholders buy the fund shares through these programs, but all shareholders bear the expense—including those who purchased shares di- rectly from the fund.
Funds provide information about themselves in two other sources. The Statement of Ad- ditional Information, also known as Part B of the prospectus, includes a list of the securi- ties in the portfolio at the end of the fiscal year, audited financial statements, and a list of the directors and officers of the fund. The fund’s annual report, which is generally issued semiannually, also includes portfolio composition and financial statements, as well as a dis- cussion of the factors that influenced fund performance over the last reporting period.
With more than 7,000 mutual funds to choose from, it can be difficult to find and select the fund that is best suited for a particular need. Several publications now offer “encyclo- pedias” of mutual fund information to help in the search process. Two prominent sources are Wiesenberger’s Investment Companiesand Morningstar’s Mutual Fund Sourcebook.
The Investment Company Institute, the national association of mutual funds, closed-end funds, and unit investment trusts, publishes an annual Directory of Mutual Fundsthat in- cludes information on fees as well as phone numbers to contact funds. To illustrate the range of information available about funds, we consider Morningstar’s report on Fidelity’s Magellan Fund, reproduced in Figure 4.5.
Nice, Light Read: The Prospectus
Dreyfus example
Old Language
The Transfer Agent has adopted standards and procedures pursuant to which signature- guarantees in proper form generally will be accepted from domestic banks, brokers, dealers, credit unions, national securities exchanges, registered securities associations, clearing agencies and savings associations, as well as from participants in the New York Stock Exchange Medallion Signature Program, the Securities Transfer Agents Medallion Program (“STAMP”) and the Stock Exchanges Medallion Program.
Total Return. The Fund may advertise total return figures on both a cumulative and compound average annual basis. Cumulative total return compares the amount invested at the beginning of a period with the amount redeemed at the end of the period, assuming the reinvestment of all dividends and capital gain distributions. The compound average annual total return, derived from the cumulative total return figure, indicates a yearly average of the Fund’s performance.
The annual compound rate of return for the Fund may vary from any average.
Plain English
A signature guarantee helps protect against fraud. You can obtain one from most banks or securities dealers, but not from a notary public.
Total Return. This tells you how much an investment in a fund has changed in value over a given time period. It reflects any net increase or decrease in the share price and assumes that all dividends and capital gains (if any) paid during the period were reinvested in additional shares. Therefore, total return numbers include the effect of compounding.
Advertisements for a fund may include cumulative or average annual total return figures, which may be compared with various indices, other performance measures, or other mutual funds.
T. Rowe Price example
Sources: Vanessa O’Connell, “Shorter, Clearer, Mutual-Fund Disclosure May Omit Vital Investment Information,” The Wall Street Journal, March 12, 1999. Reprinted by permission of Dow Jones & Company, Inc., via Copyright Clearance Center, Inc. © 1999 Dow Jones &
Company, Inc. All Rights Reserved Worldwide. “A Little Light Reading? Try a Fund Prospectus,” The Wall Street Journal, May 3, 1999. p. R1.
Reprinted by permission of Dow Jones & Company, Inc., via Copyright Clearance Center, Inc. © 1999 Dow Jones & Company, Inc. All Rights Reserved Worldwide.
Figure 4.5 Morningstar report.
Source: Morningstar Mutual Funds.© 1999 Morningstar, Inc. All rights reserved. 225 W. Wacker Dr., Chicago, IL. Although data are gathered from reliable sources, Morningstar cannot guarantee completeness and accuracy.
Some of Morningstar’s analysis is qualitative. The top box on the left-hand side of the page provides a short description of the fund, in particular the types of securities in which the fund tends to invest, and a short biography of the current portfolio manager. The bot- tom box on the left is a more detailed discussion of the fund’s income strategy. The short statement of the fund’s investment policy is in the top right-hand corner: Magellan is a
“large blend” fund, meaning that it tends to invest in large firms, and tends not to special- ize in either value versus growth stocks—it holds a blend of these.
The table on the left labeled “Performance” reports on the fund’s returns over the last few years and over longer periods up to 15 years. Comparisons of returns to relevant in- dexes, in this case, the S&P 500 and the Wilshire top 750 indexes, are provided to serve as benchmarks in evaluating the performance of the fund. The values under these columns give the performance of the fund relative to the index. For example, Magellan’s return was 0.20% below the S&P 500 over the last three months, but 1.69% per year better than the S&P over the past 15 years. The returns reported for the fund are calculated net of ex- penses, 12b-1 fees, and any other fees automatically deducted from fund assets, but they do not account for any sales charges such as front-end loads or back-end charges. Next appear the percentile ranks of the fund compared to all other funds (see column headed by “All”) and to all funds with the same investment objective (see column headed by “Obj”). A rank of 1 means the fund is a top performer. A rank of 80 would mean that it was beaten by 80%
of funds in the comparison group. You can see from the table that Magellan has had an ex- cellent year compared to other growth and income funds, as well as excellent longer-term performance. For example, over the past five years, its average return was higher than all but 8% of the funds in its category. Finally, growth of $10,000 invested in the fund over various periods ranging from the past three months to the past 15 years is given in the last column.
More data on the performance of the fund are provided in the graph at the top right of the figure. The bar charts give the fund’s rate of return for each quarter of the last 10 years.
Below the graph is a box for each year that depicts the relative performance of the fund for that year. The shaded area on the box shows the quartile in which the fund’s performance falls relative to other funds with the same objective. If the shaded band is at the top of the box, the firm was a top quartile performer in that period, and so on.
The table below the bar charts presents historical data on characteristics of the fund.
These data include return, return relative to appropriate benchmark indexes such as the S&P 500, the component of returns due to income (dividends) or capital gains, the percentile rank of the fund compared to all funds and funds in its objective class (where, again, 1% is the best performer and 99% would mean that the fund was outperformed by 99% of its comparison group), the expense ratio, and turnover rate of the portfolio.
The table on the right entitled “Portfolio Analysis” presents the 25 largest holdings of the portfolio, showing the price-earning ratio and year-to-date return of each of those se- curities. Investors can thus get a quick look at the manager’s biggest bets.
Below the portfolio analysis is a box labeled “Investment Style.” In this box, Morn- ingstar evaluates style along two dimensions: One dimension is the size of the firms held in the portfolio as measured by the market value of outstanding equity; the other dimension is a value/growth continuum. Morningstar defines value stocksas those with low ratios of market price per share to earnings per share or book value per share. These are called value stocks because they have a low price relative to these two measures of value. In contrast, growth stockshave high ratios, suggesting that investors in these firms must believe that the firm will experience rapid growth to justify the prices at which the stocks sell. The shaded box for Magellan shows that the portfolio tends to hold larger firms (top row) and blend stocks (middle column). A year-by-year history of Magellan’s investment style is presented in the sequence of such boxes at the top of the figure.
The center of the figure, labeled “Risk Analysis,” is one of the more complicated but in- teresting facets of Morningstar’s analysis. The column labeled “Load-Adj Return” rates a fund’s return compared to other funds with the same investment policy. Returns for periods ranging from 1 to 10 years are calculated with all loads and back-end fees applicable to that investment period subtracted from total income. The return is then divided by the average return for the comparison group of funds to obtain the “Morningstar Return”; therefore, a value of 1.0 in the Return column would indicate average performance while a value of 1.10 would indicate returns 10% above the average for the comparison group (e.g., 11% re- turn for the fund versus 10% for the comparison group).
The risk measure indicates the portfolio’s exposure to poor performance, that is, the
“downside risk” of the fund. Morningstar focuses on periods in which the fund’s return is less than that of risk-free T-bills. The total underperformance compared to T-bills in those months with poor portfolio performance divided by total months sampled is the measure of downside risk. This measure also is scaled by dividing by the average downside risk mea- sure for all firms with the same investment objective. Therefore, the average value in the Risk column is 1.0.
The two columns to the left of Morningstar risk and return are the percentile scores of risk and return for each fund. The risk-adjusted rating, ranging from one to five stars, is based on the Morningstar return score minus the risk score.
The tax analysis box on the left provides some evidence on the tax efficiency of the fund by comparing pretax and after-tax returns. The after-tax return, given in the first column, is computed based on the dividends paid to the portfolio as well as realized capital gains, as- suming the investor is in the maximum tax bracket at the time of the distribution. State and lo- cal taxes are ignored. The “tax efficiency” of the fund is defined as the ratio of after-tax to pretax returns; it is presented in the second column, labeled “% Pretax Return.” Tax efficiency will be lower when turnover is higher because capital gains are taxed as they are realized.
The bottom of Morningstar’s analysis provides information on the expenses and loads associated with investments in the fund, as well as information on the fund’s investment adviser. Thus Morningstar provides a considerable amount of the information you would need to decide among several competing funds.
SUMMARY
1. Unit investment trusts, closed-end management companies, and open-end management companies are all classified and regulated as investment companies. Unit investment trusts are essentially unmanaged in the sense that the portfolio, once established, is fixed. Managed investment companies, in contrast, may change the composition of the portfolio as deemed fit by the portfolio manager. Closed-end funds are traded like other securities; they do not redeem shares for their investors. Open-end funds will redeem shares for net asset value at the request of the investor.2. Net asset value equals the market value of assets held by a fund minus the liabilities of the fund divided by the shares outstanding.
3. Mutual funds free the individual from many of the administrative burdens of owning in- dividual securities and offer professional management of the portfolio. They also offer advantages that are available only to large-scale investors, such as discounted trading costs. On the other hand, funds are assessed management fees and incur other expenses, which reduce the investor’s rate of return. Funds also eliminate some of the individual’s control over the timing of capital gains realizations.
4. Mutual funds are often categorized by investment policy. Major policy groups include money market funds; equity funds, which are further grouped according to emphasis on income versus growth; fixed-income funds; balanced and income funds; asset allocation funds; index funds; and specialized sector funds.