BI > MARCH 2003

Top 10 Mutual Funds Held by NAIC Investors

Vanguard 500 Index Leads Again; Bond Fund Cracks the List

BI's Mutual Fund Survey

Battered by stock market ups and downs during 2002, participants in BI's third annual survey of mutual fund ownership found refuge in low-cost Vanguard funds. Four Vanguard stock funds were among the top 10 holdings of respondents. A fifth Vanguard fund, Vanguard GNMA Fund, is the first bond fund to make the survey's top 10. Stock funds from four other fund families make up the balance of the list.

While past results vary, NAIC investors consistently own many of the same large funds as many other Americans. All the funds in the survey are among the 30 largest funds in the United States as of Dec. 13, 2002, according to Morningstar. The Vanguard 500 Index Fund, the largest stock fund with assets of $72.3 billion, holds the top position in the survey for the third year in a row.

Large blend funds edge out other funds in the survey results. Blend funds combine characteristics of value and growth funds. Four of the top 10 funds are large blend funds, followed by three large value, two large growth, one specialty health-care and one intermediate-term government bond fund. There are two index funds and eight actively managed ones. An index fund attempts to replicate the performance of a particular market index, while actively managed funds have managers who pursue a particular investing strategy in line with a fund's objective.

Managers of the top 10 have made long-term commitments to their funds. The average manager tenure is 9.5 years. Jon Lovelace, Jr., one of 10 managers of the American Funds Group's Investment Company of America fund, has the longest tenure at nearly 44 years. The newest manager of a survey fund is David Fassnacht, CFA, with two years at Vanguard Windsor; he's one of the fund's four managers.

In an era in which funds come and go, the longevity of the top 10 funds is remarkable. The oldest fund is Investment Company of America, launched in 1934. Other funds with long histories are American Funds Washington Mutual Fund, which began in 1952, and Fidelity Magellan, which started up in 1963. The youngest fund is Vanguard Total Stock Market, which debuted in April 1992.

"While the survey is a good place to look when considering funds for purchase, be sure to evaluate them and any other funds using the tools in the NAIC Mutual Fund Program: the Equity Mutual Fund Check List, the Equity Mutual Fund Comparison Guide and the Equity Mutual Fund Trend Report," says Dennis Genord, NAIC's mutual fund education manager.

Funds are discussed in order of their appearance in the survey results. Each fund's ticker symbol, Morningstar category, taxable fund account minimum purchase and load status is listed. Minimum purchase amounts for IRAs and automatic investment accounts for each fund may differ from the minimums shown here for each fund.

Vanguard 500 Index Fund

Ticker Symbol: VFINX

Morningstar Category: Large Blend Stock

Minimum Purchase Amount: $3,000

Load: None

The nation's biggest stock fund and the biggest index fund still holds the top spot for NAIC investors responding to the survey. Vanguard 500 Index Fund, which attempts to track the S&P 500's performance, was the first such fund when it was launched by Vanguard founder John Bogle in 1976. Doubters at the time didn't believe it could succeed, and many feel the bear market brings out the flaws in an indexing strategy.

Proponents of actively managed funds believe that a good fund manager can pick stocks better than the average investor can, creating value for fund investors. Indexing proponents such as George "Gus" Sauter, manager of the Vanguard 500 Index Fund, believe that the key to success in the stock market is buying and holding a broad segment of the overall stock market.

Index-fund critics point to statistics that show actively managed funds faring better against index funds during the recent bear market than during the prior bull market as a justification for pursuing actively managed funds. "Indexing has done just fine in the past three years," Sauter counters. "It's not unusual in a short period of time to see actively managed funds doing better than index funds in certain areas of the market, such as small-cap investing. But during a longer period of time such as 10 to 15 years, indexing will dominate."

One reason Vanguard's index funds perform well against actively managed funds is their low cost structure. As the only mutually owned mutual fund company in the United States -- investors in the firm's mutual funds are the company's ultimate owners -- Vanguard passes on its savings to shareholders in the form of low expenses; other fund companies must show a profit on their fund operations.

The Vanguard 500 Index Fund's expense ratio is 0.18 percent: Investors with $10,000 in fund shares pay $18 a year in operating expenses. Large-cap mutual funds have an average expense ratio of more than 1 percent.

Sauter is optimistic about the stock market's prospects in the coming five to 10 years. "The market is on sale right now," he says. "Stock market investors are the only shoppers who don't like sales. This is the time to buy, not to sell. We're in a normal market cycle -- rather severe in terms of the downturn that the market has suffered, but not as severe with the economy in general, which is still growing.

"Investors are reacting to the downturn in a typical fashion. Most investors operate in the market with fear and greed -- greed is rampant at the top and fear at the bottom. I can't say if we're at the bottom of the market right now, but if you liked the market three years ago you've got to love it now."

Vanguard Health Care Fund

Ticker Symbol: VGHCX

Morningstar Category: Specialty / Health Care Stock

Minimum Purchase Amount: $25,000

Load: None

Vanguard Health Care is the only sector fund in the top 10; the other stock funds invest in a broader portion of the overall market. As a sector fund, Vanguard Health Care seeks long-term growth of capital by investing in the shares of firms in health-care-related industries. It spreads its assets among pharmaceutical, biotechnology, insurance and health management companies as well as for-profit hospital chains, drugstores and other health-care-related firms.

Manager Ed Owens declined to be interviewed, but he shared his outlook on the market and on the fund in his report to shareholders in August 2002: "The slow economic recovery, combined with reduced investor confidence in corporate management and financial statements, depressed equities generally. Despite their limited sensitivity to the broader economy, health-care stocks were not spared. Nevertheless, the future fundamentals of the sector and the industry's potential to develop and sell breakthrough medicines remain unchanged.

"We took advantage of the weakness in pharmaceutical and biotechnology stocks to increase our exposure to these sectors during the last six months. The fund is now more aggressively positioned than it has been in several years, while still retaining its traditional diversification and attention to value. We are hopeful that the largest part of the stock market decline is behind us, but still do not expect a return to the euphoria of the late 1990s."

This fund is by far the best performer in the top 10. Both short- and long-term results are strong, including a five-year average total return of 15.5 percent, which beats the S&P 500 by 14.5 percentage points. Investor reaction to the fund's performance has been so strong that Vanguard moved to slow asset flow in 2001 by raising the investor minimum for all types of accounts to $25,000.

Despite the increase, this remains one of the largest sector funds in the market, with assets of $14.1 billion as of December 2002. Its five-year turnover rate is quite low at 15.2 percent, illustrating Owens' buy-and-hold investing strategy. A fund's turnover rate is a rough measurement of how much buying and selling a fund manager does during a particular period.

Vanguard Total Stock Market Index Fund

Ticker Symbol: VTSMX

Morningstar Category: Large Blend Stock

Minimum Purchase Amount: $3,000

Load: None

While Vanguard 500 Index is the largest stock fund in the United States, fund manager George Sauter believes the top position should belong to another fund he manages, the Vanguard Total Stock Market Index Fund. The Total Stock Market fund is a better way to gain exposure to the entire U.S. stock market, says Sauter, managing director of Vanguard's Quantitative Equity Group. The fund allows you to "combine investing in large-, medium- and small-sized companies in a one-stop shopping approach."

The broadly based Total Stock Market Index Fund includes many mid-, small- and micro-cap companies, unlike the Vanguard 500 Index Fund, which focuses on the nation's largest companies. While the Vanguard 500 Index Fund outperformed the Total Stock Market Index Fund during the late 1990s when large-cap stocks were in favor, Total Stock Market will perform better in different market environments and is less volatile, according to Sauter.

Total Stock Market currently uses the Wilshire 5000 index as its proxy. Vanguard shareholders have approved a plan to let fund trustees change the benchmark index for this fund and a number of other Vanguard index funds. The composition of this fund is unlikely to change, however, because any other benchmark would have to closely follow the entire U.S. stock market, as the Wilshire 5000 does.

Rather than focus so much attention on which fund to invest in, investors should spend more time considering their overall asset allocation, Sauter says. "Most investors spend 95 percent of their time and energy deciding which fund to invest in," he says. "They would be better served spending 95 percent of their time figuring out how much they want to invest in stock, bonds and cash."

The fund's expense ratio is a slim 0.20 percent, more than a percentage point below that of the average large blend fund. Because the fund buys and holds many of the companies in the Wilshire 5000, its five-year average turnover rate is an extremely low 4 percent. The fund invests in firms in every market capitalization segment: giant, 39.1 percent; large, 30.3 percent; mid, 20.3 percent; small, 7.1 percent; and micro, 3.2 percent.

Vanguard Windsor Fund

Ticker Symbol: VWNDX

Morningstar Category: Large Value Stock

Minimum Purchase: $3,000

Load: None

The most popular large value fund in the survey, Vanguard Windsor Fund splits its assets between two fund advisers. Wellington Management Company manages 71 percent of the fund, while Sanford C. Bernstein & Co. manages 26 percent. The remaining 3 percent is in cash.

The lead portfolio manager, Charles Freeman of Wellington Management, cites his team's consistent application of value-oriented principles as the reason for the fund's success.

"Our portfolio typically is valued at a one-third discount to the market," Freeman says. "We buy well-managed, well-positioned and well-financed companies that for one reason or another have fallen on hard times. We opportunistically seek companies in these situations and are always ready to jump on a good value when it appears."

Wellington's portion of the fund's assets is concentrated, especially in the top holdings. "We're willing to make a substantial bet on companies that we like, and when they do well, that will contribute significantly to the fund's total return on the upside," Freeman says. "One reason we like stocks with low P/Es is that expectations are lower, so if we're right, we have good upside potential, and if we're wrong, it is easier to sell it back and move on. Of course, things don't always work out that way."

The fund's recent performance has lagged because it held positions in firms such as WorldCom, Adelphia and Tyco. While Adelphia and WorldCom have declared bankruptcy, Tyco is still a going concern. Freeman has added to the fund's Tyco position, which is the seventh-largest holding in the portfolio. Freeman likes the company's new CEO, Ed Breen, and believes Tyco has worthwhile businesses with strong growth potential and room for P/E expansion, given the market's low expectations for the company.

Citigroup, Washington Mutual and IBM are among the fund's top holdings. While classified as a large-cap fund, Vanguard Windsor also has 38.4 percent of its holdings in mid-cap companies. This is an actively managed fund, but it also holds with Vanguard's low-cost approach. The expense ratio is 0.41 percent.

American Funds Investment Company of America (Class A)

Ticker Symbol: AIVSX

Morningstar Category: Large Value Stock

Minimum Purchase: $250

Load: 5.75% Front-End

As a large value fund, the Investment Company of America fund holds many dividend-paying companies. In a Morningstar report that analyzed the fund's portfolio as of June 30, 2002, it held a sizable stake in bonds and cash, leaving only three-quarters of the fund's assets invested in stocks.

The fund has 14.5 percent of its assets in bonds, and two of the fund's top 10 portfolio holdings are bonds. Managed by 10 people who act independently of one another, the fund tends to hold higher stakes in bonds and cash so that it won't be as volatile as funds that are fully invested in stocks. While such a strategy can hold down volatility, it can also dampen returns when stocks are in favor.

Investment Company of America's large positions in dividend-paying stocks, cash and bonds have led to a poor tax-efficiency record. In fact, this fund is less tax-efficient than some bond funds. Investors interested in this fund should consider holding it in a tax-deferred account, where its tax inefficiency would have less impact than it would in a taxable account.

Managers keep turnover low, holding on to their stock and bond picks for several years. The five-year average turnover rate is 25.5 percent, far below the category average of 75 percent.

The fund has a strong long-term track record, with an average 10-year total return of 11.1 percent. Year-to-year performance numbers are fairly consistent, and 2001 was the fund's only down year since 1992.

While the expense ratio is low, investors who purchase shares in Investment Company of America pay a 5.75-percent front-end load. Front-end loads cut into total return and reduce the initial amount of money an investor has to invest in a fund.

Janus Fund

Ticker Symbol: JANSX

Morningstar Category: Large Growth Stock

Minimum Purchase: $2,500

Load: None

Closed by Janus in fall 2000 to stop torrents of assets from flooding into this popular fund, Janus Fund reopened to new investors at the end of 2002. The bear market not only has affected the fund's asset size, but performance downturns also have prompted investors to leave this large-growth fund.

While Janus Fund's short-term record doesn't look great, especially compared with its peers and the market indexes, its long-term track record is better. The 10-year average annual total return is 8.6 percent, and the 15-year average annual total return is even better at 10.4 percent.

Blaine Rollins, the assistant portfolio manager for many years, took over the fund in January 2000 when longtime manager Jim Craig retired. Rollins retained many of the same holdings that Craig had purchased and kept essentially the same investment philosophy in place.

Janus Fund's five-year average turnover rate is 76.2 percent. While that's higher than the 20 percent NAIC investors like to see, the rate is still nearly 40 percentage points lower than the large growth category average of 116 percent. This no-load fund's expense ratio of 0.83 percent is also lower than the category average.

American Century Ultra Fund

Ticker Symbol: TWCUX

Morningstar Category: Large Growth Stock

Minimum Purchase: $2,500

Load: None

American Century Ultra Fund is a large growth fund that holds many well-known names. Its top 10 holdings include Pfizer, General Electric, Microsoft and Citigroup. More than a quarter of its portfolio is concentrated in its top 10 holdings.

Beyond the largest holdings, the portfolio broadens out with a total of 210 companies. Nearly 80 percent of the holdings are in giant- or large-cap firms. Mid-caps make up 16.8 percent of the portfolio; small-caps, 3.5 percent; and micro-caps, 0.1 percent.

Like many large-growth funds, American Century Ultra experienced a big run-up in total return in the late 1990s during the tech stock boom. The fund was up 23.1 percent in 1997, 34.6 percent in 1998 and 46.5 percent in 1999. Cash poured into the fund, and assets skyrocketed from $18.4 billion in 1996 to $43.2 billion in 1999. Both total return and net assets declined during 2000, 2001 and the first 11 months of 2002, in line with many other large growth funds.

The fund's experienced managers seek fast-growing companies, as evidenced by its portfolio earnings growth rate of 19 percent. This is faster than its fund peers and the S&P 500 index. The portfolio's P/E ratio is 20.

Fidelity Magellan Fund

Ticker Symbol: FMAGX

Morningstar Category: Large Blend Stock

Minimum Purchase: Closed

Load: 3% Front-End

Fidelity Magellan vies with the Vanguard 500 Index Fund for the title of the largest stock fund in the United States. Fidelity held that title for many years until the Vanguard 500 Index Fund snatched it away. In 2002 both were briefly usurped by a bond fund, PIMCO Total Return, as the steady returns of bond funds attracted investors. Although Magellan's asset base has fallen, it still holds the title as the largest actively managed stock fund in the United States.

Bob Stansky has managed this fund since Sept. 1996, following in the footsteps of Peter Lynch. The fund that Stansky manages, however, is far larger than the one that Lynch managed. This limits management's flexibility, especially in terms of investing in the small-cap stocks that have the biggest appreciation potential.

Fidelity Magellan's record against its benchmark, the S&P 500, is mixed. It beat the index four of the 10 years between 1992 and 2001, hardly a stellar record. The picture changes a bit when looking at overall average total returns. As of Nov. 30, 2002, Magellan was beaten by the S&P 500 in the trailing three- and 10-year periods by a scant 0.04 percentage point. But it led the index by about 1 percentage point in both the trailing five- and 15-year periods.

Although the fund is closed to most new investors, many can access it through their 401(k) or 403(b) accounts. Investors who already own shares can continue to purchase new shares. The fund carries a 3-percent front-end load.

Fidelity Magellan concentrates its assets, like several of the other top 10 funds, in well-known names such as Wal-Mart, Pfizer and Home Depot. More than 90 percent of the fund's assets are in giant- or large-cap firms.

Vanguard GNMA Fund

Ticker Symbol: VFIIX

Morningstar Category:Intermediate Government Bond

Minimum Purchase: $3,000

Load: None

Vanguard GNMA Fund is the first bond fund to make the top 10. Many bond funds have gained assets as investors fled falling stock funds. This fund is now the second-largest bond fund in the United States, with $27.2 billion in assets as of Dec. 13, 2002, according to Morningstar data.

Classified as an intermediate-term government bond fund, Vanguard GNMA invests at least 80 percent of its assets in mortgage-backed securities issued by the Government National Mortgage Association (GNMA). The fund's remaining assets are restricted to investment in U.S. Treasury securities or U.S. government agency securities.

The fund's impressive short-term total return numbers are due not only to Vanguard's low costs and the fund manager's skills but also to declining interest rates. When interest rates fall, the prices of existing bonds paying higher interest rates increase. The fund's three-year total return is 9.5 percent. While lower, the longer-term total return numbers are still strong and beat out comparable market indexes during the five- and 10-year total return periods.

Unlike many other types of government securities, mortgage-backed securities are subject to prepayment, as holders of mortgages refinance their loans to capture lower interest rates. This hurts mortgage-backed funds because bonds with higher interest rates are repurchased, and the fund is forced to purchase new mortgage-backed securities at lower interest rates.

The fund and virtually all other types of bond funds may also suffer low or negative total returns in the future if interest rates increase. Rising interest rates render existing bonds less valuable than newly issued bonds, bringing down the net asset value of bond funds.

Like the other Vanguard funds in this survey, Vanguard GNMA has a very low expense ratio of 0.27 percent, which is slightly less than a percentage point lower than the average for the intermediate government bond category. Low expenses can make a big difference for bond funds because their total returns tend to be lower than those for stock funds in the long term.

American Funds Washington Mutual Fund (Class A)

Ticker Symbol: AWSHX

Morningstar Category: Large Value Stock

Minimum Purchase: $250

Load: 5.75% Front-End

A second offering from California-based American Funds shares a similar strategy with the firm's Investment Company of America fund: Both are large value funds with assets divided among several experienced managers. The funds currently are about the same size, with Investment Company of America nudging the Washington Mutual fund out by $4 billion in December 2002.

Washington Mutual favors dividend-paying companies but held less in cash and bonds than Investment Company of America did as of June 2002. Stocks constitute 97.6 percent of the fund's assets. The stocks are almost entirely domestic companies; only 0.1 percent are in foreign firms. Assets are heavily weighted toward large-cap companies, which make up more than 80 percent of the portfolio.

Like its sibling fund, American Funds Washington Mutual isn't a tax-efficient fund, and investors considering purchasing shares may want to hold them in a tax-deferred account. The fund's average portfolio earnings growth rate is 12 percent, and the average P/E ratio is 16.7.

While the expense ratio is a fairly low 0.65 percent, this fund carries a 5.75-percent front-end load and is primarily sold through brokers and financial planners who get a commission for providing investment advice. If you invested $10,000 in this fund, $575 of that investment would go to pay brokers' fees, with the remaining $9,425 going to purchase fund shares.

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.