Monday, January 23, 2012

If we could design the mutual fund landscape from the ground up...

Our previous post discussed the poor results of mutual funds in 2011 at least partly due to the prevalence of closet indexing.  So it was refreshing to see that one company is doing something really different.  This article in the Christian Science Monitor talks about a new fund from Gamco Investors called "Focus Five."  A full 50% of the fund will be invested in only 5 stocks — what the company calls its best ideas.  The remaining 50% of the fund will still be focused relative to the rest of the market, investing in between 10 and 20 stocks.

Now, it remains to be seen whether Gamco will be any good at stock picking.  But whether they fly high or crash and burn, you'll at least know why.  Their disclosures will be crystal clear, leaving no mysteries, so that it will be easy to hold them accountable for their picks.

It makes one think about a different way mutual funds could be built if one had the opportunity to rebuild the ecosystem from scratch.  One could imagine that investors desiring active management would split each asset class exposure between two funds - a passively managed index fund and a small, highly focused fund with few holdings.  Investors would then get their market exposure cheaply, as they should, in a fund that is an index fund and says so.  That wouldn't be muddied together with active picks — bringing transparency and accountability to those picks.

It will probably never happen — investors may not like the complexity of using lots of funds, and they could hurt their returns badly if they overload on a single, badly-chosen focused fund – but it's an interesting idea, and one we may hear more about if Gamco has success.

Tuesday, January 17, 2012

2011: A terrible year for mutual funds

A Businessweek article by Lu Wang last week which reported on the terrible year mutual funds had in 2011 should give investors a lot to chew on when selecting funds.  The facts are stunning – only 17% of actively managed large-cap funds beat their benchmark.  What might this mean for investors going forward and what are the implications for how mutual funds are rated?

We have written about closet indexing before, and it's important to consider that 2011 may be a result of the trend noted in some academic studies that closet indexing is increasing.  The Businessweek article also points out that correlations among stocks were at a record high in 2011, making stock picking more difficult.  This is known to happen in rough times before, but what good are historical analyses if such fundamental things can change so quickly?  Would something like Active Share be a better measure to use in such times?

There are many open questions, but we do think that in times like these, analysis based on holdings could give investors a valuable, different view into funds.