BI > MARCH 2003

Caught in Shifting Tides

Revisiting the 2001 Survey

When readers responded to BI's first mutual fund survey in late 2000 -- the results were published in the February 2001 issue -- the market landscape was quite different from the one they face today. At that time many growth funds were still in favor, and market experts were optimistic that a turnaround would come soon.

This is reflected in the survey's responses. Three Janus funds were in the top 10, all sporting five-year total returns of more than 20 percent. The worst-performing fund in the survey, American Century Ultra, had a five-year total return of 18.8 percent (see this month's cover story for the current survey).

What a difference two years makes. As of Aug. 31, 2002, American Century Ultra's five-year total return was barely in positive territory at 1.8 percent. Janus Twenty, the best performing fund in that first survey, had a five-year total return of 2.4 percent as of the same date. In 1999 Janus Twenty's return was 64.9 percent; in 2002 it was -29.2 percent.

The market downturn of the past three years has spared few funds and fund sectors. As of August 2002 the average large-cap blend fund's five-year total return was 0.5 percent. The average large-cap value fund has fared a bit better, with a five-year total return of 0.7 percent. The five-year total return for the average large-cap growth fund was -1.1 percent.

Distorted Rear-View Mirror

Amid the carnage, one lesson for NAIC investors is that bear markets are an ongoing aspect of investing in stocks and that just about every type of company and every type of mutual fund will be hurt to some degree.

A second important lesson is that diversification cushions, but doesn't eliminate, market risk. In the most recent downturn, a portfolio tilted heavily toward growth funds suffered more than a more diversified portfolio did. Averages don't tell the whole story, either: There is wide divergence among results for individual funds, with tech-heavy offerings falling further than those with more diverse portfolios.

Total returns are skewed when markets rise or fall rapidly. In 1999 many funds had incredible long-term records, with five- and 10-year total returns frequently above 25 percent. Those records are equally skewed today, with many growth, value and blend funds having long-term total returns below 10 percent.

A mediocre fund in a popular category can look great, while a superior fund in an out-of-favor category may look terrible. While total return is a bottom-line number, past performance truly isn't indicative of future results. Fund investors are wise to weigh many other variables -- such as manager tenure, portfolio holdings, costs and turnover -- before purchasing shares in a particular fund.

The Rise and Fall of Janus Funds

Janus Funds played a major role in the story of investing in the late 1990s and early 2000s. Janus Funds rode the wave of growth investing to an incredible high in the 1990s. By investing early in such technology and telecommunications growth favorites as Cisco, Nokia and EMC, Janus delivered breathtaking returns as investors flocked to these funds.

As a fund family Janus emphasized its research-driven investment philosophy, and it primarily focused on growth stocks in its growth funds. In that first survey Janus Fund was tied for No. 1 with the Vanguard 500 Index Fund. Janus Worldwide was in third place and Janus Twenty in fourth.

Assets rose quickly for many Janus funds during the 1990s. In 1991 Janus Fund had assets of almost $3 billion. By 1999 assets had risen more than tenfold to $42.3 billon through a combination of appreciating stock and investor interest. Not surprisingly, by August 2002 assets had fallen to $17.3 billion. Assets invested in Janus Worldwide and Janus Twenty followed a similar pattern (see graph,below). Janus closed all three funds to new investment when assets ballooned but has reopened Janus Fund and Worldwide.

Click to enlarge.

These trends illustrate how many investors pile into winning funds when they're at their height. Many of the investors who poured money into Janus funds in 1999 no doubt reaped little of the positive performance and much of the painful downturn that followed.

Growth, like other investing styles, goes in and out of favor. All investing styles are subject to market cycles. Value was very much out of favor in the mid- to late 1990s but had its time in the sun during 2000 and 2001.

Will Janus return to its former glory? Some of the family's funds have deviated from a pure growth strategy in an effort to stanch the bleeding in net asset value. When growth comes into favor again, however, these funds may not benefit as much as other funds that stayed true to growth investing.

The Vanguard 500 Index Fund

Among the other top vote-getters in the first survey, the Vanguard 500 Index Fund's five-year total returns have followed the market down, from 21.6 percent in October 2000 to 1.7 percent as of June 30, 2002. This fund was No. 1 in the survey in 2001 and 2002. The Vanguard 500 Index Fund attempts to replicate the performance of the S&P 500 index, which is composed of America's largest companies.

The fund flourished as large-cap names dominated the market in the mid- to late 1990s, beating many actively managed funds. An actively managed stock fund is one run by a portfolio manager who selects stocks for purchase and sale from the fund portfolio. A stock index fund, by contrast, buys the companies in a particular market index.

While the Vanguard 500 Index Fund currently isn't ahead of as many actively managed funds as it once was, its low expenses give it an edge. The fund's expense ratio is 0.18 percent, significantly lower than the large-blend category average of 1.24 percent. The expense ratio expresses the percentage of assets an investor pays in fund operating expenses. It doesn't include brokerage commissions and sales charges.

An investor who purchased $10,000 of shares in Vanguard 500 Index, for example, would pay $18 in operating expenses a year, as opposed to $124 for investors in the average large-blend fund. This is a significant difference of $106 per year. When fund returns were high, expenses didn't seem to matter so much. But they can make a big difference in how much of the fund performance reaches your bottom line.

Index funds such as the Vanguard 500 Index Fund also have low turnover ratios. The turnover ratio is a rough measurement of how often a fund manager buys and sells stock in a fund portfolio. Actively managed funds generally have higher turnover ratios, which lead to higher brokerage costs and lower tax efficiency.

Some Success Among Other Funds

The remaining six funds in the top 10 were specialty funds Vanguard Health Care and T. Rowe Price Science and Technology as well as American Century Ultra, Fidelity Magellan, Investment Company of America and Fidelity Contrafund.

Vanguard Health Care delivered stellar performance in both late 2000 and 2002. Its five-year total return as of June 30, 2002, was 17.3 percent. The fund proved so popular with investors in 2000 that Vanguard upped the minimum investment requirement to $25,000 for regular and IRA accounts. The minimum investment remained in place as of late 2002, leaving the fund out of reach for many investors.

But T. Rowe Price Science and Technology has stumbled along with the technology sector and reported a negative five-year total return of -5.9 percent as of June 30, 2002. Sector funds can be quite volatile because they invest in a small portion of the overall market. Think carefully before you invest in any sector fund -- no matter how successful -- because sectors rotate in and out of favor. Most funds with a broader mandate invest in a variety of sectors, from health care to technology.

Fidelity Magellan, the nation's largest actively managed fund, has also seen its total return and asset base fall. Turnover plummeted from 155 percent in 1996 to 15 percent in the first eight months of 2002. The fund has narrowly outpaced the S&P 500 index for the three- and five-year total return periods but has fallen behind by 0.1 percent for the 10-year total return period.

Investment Company of America, a large value fund, has ridden out the market decline in better shape than many large growth and blend funds have. It sported a five-year total return of 4.7 percent as of July 31, 2002.

Fidelity Contrafund has bucked the large growth trend and delivered a five-year total return of 5.6 percent as of Aug. 31, 2002, outpacing the S&P 500 index by 3.9 percent.

Overall market trends have a profound influence on just about any type of mutual fund. Long-term investors realize that funds, individual companies and stock investing itself go in and out of favor.

Successful long-term investors do well to stick with low-cost, low-turnover funds with stable management in good times and bad.

Amy Buttell Crane, a free-lance writer based in Erie, Pa., writes about mutual funds for BetterInvesting Magazine Amy is the author of the second edition of BetterInvesting's Mutual Fund Handbook. She also has taught stock and fund investing classes.