Copyright © 2012 by Institute of Business & Finance. All rights reserved.

MINI-COURSE SERIES

MUTUAL FUNDS

Part VI

MUTUAL FUNDS 1

PART VI

IBF | MINI-COURSE SERIES

LOOK AT COSTS

Fund expense ratios vary widely and high-cost funds do not have better managers than

low cost funds. Funds with higher expense ratios tend to lag cheaper funds. In a 2002

Morningstar study, all of the funds in each Morningstar category were divided into one of

four groupings based on their expense ratio in 1996: the highest cost 25%, the next high-

est cost 25%, the second cheapest 25%, and finally, the cheapest 25%.

In all categories, low-cost funds outperformed high-cost funds over the subsequent

five-year period. For small company growth funds, for example, the cheapest 25% pro-

duced annualized five-year returns of 8.5% between 1996 and 2001, whereas the highest

cost 25% produced returns of 7.0%. For large blend funds, the advantage was narrower

but still significant—1.2% a year.

The Morningstar study also looked at those funds with high expenses and the top 25%

returns in the period from 1991 to 1996. The group’s subsequent five-year performance

was then compared to the subsequent five-year returns of low-cost funds that landed in

their categories’ bottom 25% from 1991 through 1996. Over the ensuing five years, from

1997 through 2001, the cheap funds with poor track records outperformed the high-cost

funds with strong past returns.

We also look favorably on fund companies that try to keep their trading costs to a bare

minimum. American Century, for example, pays less than one cent per share, on average,

to execute its trades, while the industry average is five cents per share.

ACTIVE OR PASSIVE MANAGEMENT

There are a number of actively managed funds that have consistently outperformed their

index benchmarks. And there is evidence indicating that so-called “sophisticated money”

directs assets to such managers. The great majority of academic studies are strong ad-

vocates of passive management (indexing). Their argument is based on three points: (1)

market efficiency, (2) the expense drag of hiring costly analysts, managers, researchers,

and traders, and (3) the “hidden” costs of trading—brokerage commissions, impact costs,

and bid-ask spreads.

MUTUAL FUNDS 2

PART VI

IBF | MINI-COURSE SERIES

A number of studies show that indexing tends to be more effective in some investment

styles than in others. Funds that focus on large cap U.S. stocks invest in the most closely

watched stocks in the world. Funds that venture outside the large cap arena have many

more stocks to choose from—there are more than seven hundred U.S., mid cap stocks

and more than four thousand small caps to sort through (versus about 250 domestic large

cap issues). And more importantly, those stocks receive far less attention from the finan-

cial community. So it is more likely that a manager could ferret out an underappreciated

gem in the mid or small cap area than in the large cap realm.

BOND MARKETS, INDEXES AND FUNDS

The U.S. bond market is valued at roughly $32 trillion (2011); $87 trillion worldwide.

The Barclays Aggregate Bond Index is comprised of more than 7,000 different bonds,

many of which are so illiquid that fund managers cannot buy, even if they wanted to. R-

squared reflects the percentage change of a fund’s fluctuation that can be explained

by the change in its benchmark index. A fund that highly corresponds to its respective

index has an R-squared in the high 80s or 90s. For the 10-year period ending September

2006, only two of 15 funds with 10-year R-squared of 98 or higher outperformed the

Barclays Aggregate Bond Index. Fund expenses prevented the other 13 possible funds

from outperforming the index.

The advisor who is seeking index-type returns will have to either choose low expense

funds or portfolios that have securities different than their respective index—specifically,

high-yield issues. Defaults on U.S. junk bonds for the 2006 calendar year were 1.3%,

just under 1.0% for 2007, well below the historical average of 4.5%, as computed by

S&P. In November 2009, the junk bond default rate peaked at an annualized rate of

14.5%. The actual default rate for all of 2009 was 13.7%; 151 issuers defaulted on a

record $119 billion in bonds. Moody’s expected the default rate to fall to 3.3% by the end

of 2010. Surprisingly, for the first five months of 2010, the annualized rate was just 1%;

nine issuer defaults, a cumulative total of $1.7 billion (source: Fitch).

Before discounting the importance of bonds, consider: From January 1st, 2000 to Decem-

ber 31st, 2002 (three very bad years for most domestic large cap stocks), a $100,000 in-

vestment in the S&P 500 fell to $62,406 while a $100,000 investment in the Barclays

Aggregate Bond Index grew to $133,466. The following table compares the total return

from 7-10 U.S. Treasury bonds versus the S&P 500 for periods ending 12-31-2011.

Total Return: S&P 500 vs. Treasury Bonds [through 12-31-2011]

2011 3 Years 5 Year 10 Year

7-10 Year Treasurys 15.6% 5.9% 9.1% 7.1%

S&P 500 2.1% 14.1% -0.3% 2.9%

MUTUAL FUNDS 3

PART VI

IBF | MINI-COURSE SERIES

WHEN A FUND CLOSES ITS DOORS

When a fund is about to close its doors to new investors there is frequently an on-

slaught of new money that pours in. The belief is that the fund is almost magical.

The reality is something different.

A mutual fund advisory service looked at close to 40 funds that closed during a recent 15-

year period. The funds’ performance was ranked for the three-year period before closing

its doors and for the three-year period after new investors were barred. For every fund

whose subsequent performance improved, three times as many funds experienced a

decline in returns. Compared to the performance of their respective peer groups, the

closed fund fell from the top quintile of returns to just below average.

Another problem investors face when a fund closes its doors is increased tax inefficiency.

When a fund is using inflows of new cash, the need to redeem securities to pay for re-

demptions or to acquire other securities lessens the triggering of capital gains. One study

shows that the average closed fund’s tax efficiency fell 5% after its closing date. One

mutual fund family has publicly stated that the negative tax consequences of closing out-

weigh the pluses.

If your client is intent on chasing a fund about to close, there is another course of

action—find out what other funds the manager oversees. More likely than not, if there

are other offerings, portfolio composition will be similar.

SERIAL CORRELATIONS

Serial correlation, also known as the first-order autocorrelation, measures the ex-

tent to which the return in one period is related to the return in the next period. Un-

like correlation coefficients, a serial correlation only has to do with a single asset catego-

ry. Serial correlations range from a negative number to positive 1.00. The table below

shows serial coefficients of several different asset categories (REITs = real estate, EAFE =

foreign stocks, LCS = large cap stocks, SCS = small cap stocks, LTB = long-term U.S. Government

bonds, and MTB = med-term U.S. Government bonds). Excluding T-bills, there is virtually

no relationship between returns of most assets from one year to the next.

Serial Correlations Coefficients [1970-2010]

REITs EAFE LCS SCS LTB MTB T-bills

Serial Correlations 0.1 0.1 0.0 0.0 -0.3 0.0 0.8

MUTUAL FUNDS 4

PART VI

IBF | MINI-COURSE SERIES

THINGS TO DO

Your Practice

Harley Davidson’s make a special noise that is actually patented. What noise are you

making? Without making yourself known, you could be the best-kept secret in your

community. Think of ways to make an impression.

The Next Installment

Your next installment, Part VII, will cover five topics: standard deviation, beta, R-

squared, alpha, and duration. You will receive Part VII in a week.

Learn

Are you ready to take your practice to the next level? Contact the Institute of Business &

Finance (IBF) to learn about one of its five designations:

o Annuities – Certified Annuity Specialist®

(CAS®)

o Mutual Funds – Certified Fund Specialist® (CFS

®)

o Estate Planning – Certified Estate and Trust Specialist™

(CES™

)

o Retirement Income – Certified Income Specialist™

(CIS™

)

o Taxes – Certified Tax Specialist™

(CTS™

)

IBF also offers the Master of Science in Financial Services (MSFS) graduate degree. For

more information, phone (800) 848-2029 or e-mail adv.inv@icfs.com.