In the Segmented World of Funds, Beware of False Crowns

Mutual Funds

Fund Manager Paul Hogan is said to beat 99% of his peers that he shares a part of the investment forest with. This can allow us to fail but still be able to brag about the failure.

You would think that the world of mutual funds would be set up so that we may compare the results of all funds with one another to at least get some idea of how they may compare. After all, that’s what people want to know when they look at these things.

It’s not that people don’t do this, but we’ve discovered a way to narrow the field for these participants by using segmentation, grouping funds by many different categories and then comparing them within the category.

While there may be reasons to distinguish funds based upon the type of funds that are held, if we want to look at performance, this will require that we judge funds based upon their actual performance overall and not just how they measure up within their own category.

Fund manager Paul Hogan of the FAM Dividend Focus Fund is being celebrated as the king of Morningstar’s Mid-Cap Blend category, where he has been shown to have beaten 99% of his peers over the last 5 years. If we restrict what qualifies as a peer narrowly enough though, or even restrict it at all, this may not be meaningful.

If it were somehow the case that an investor was restricted to investing in mid-cap blend funds, which would mean that all other types of funds went out of business and this were the only type that was left, and they also made a law that you had to buy an actively managed fund rather than going with the market or picking your own stocks, then this would mean something.

Since this isn’t the case at all, we also need to know how this feat measured up to things like letting your young kids pick stocks at random as well as all of the other strategies out there. If we can at least beat the kids, then we may actually have something of value to offer, otherwise, we should not only refrain from being smug, and instead, we should take a serious look at why we are even doing this, leading our clients down a path that will reduce their returns over random instead of improving them.

The benchmark for actively managed mutual funds is the S&P 500, and even though some may wish to fudge this by comparing their results to narrower indexes like mid or small cap ones, if they don’t beat the broad market, investors could have just went with an S&P index fund and beaten them.

Seeing Hogan propped up on the shoulders of some other financial writers may have them look good to their readers, but being the king of a particular mutual fund pond still requires that we examine the merit of these funds overall by putting them in the big pond to see if they can swim with bigger fish or even the average fish out there.

Beating the Market with Your Fund is an Absolute Minimum Criterion

Since his fund has the word dividend in it, that excites some people, but regardless of the investment strategy that your fund uses, measuring performance always comes down to looking at the performance results themselves, and they have to measure up. If they underperform, that’s how we need to see them, regardless of whether they beat 99% of the fund managers in their category or not, which is actually a meaningless distinction in itself.

It is possible in theory at least to beat every other fund manager out there period, the mid-cap blend ones or otherwise, and still fail to beat the market, but we do know that about 22% of funds do succeed in beating the market, and some beat the market by a massive amount, like 10 times the return.

We do need to categorize our funds, but not based upon things like sector or market capitalization, but by performance. We do require a baseline here, and the S&P does serve to be a good one and the best one out there for practical purposes, because this is where the line gets drawn where you’d be better or worse off just going with the market instead.

We need to actually take this comparison further and measure performance by how much we beat or fell behind the market, as in a stock outperforming it or underperforming it by a certain percentage. The nominal returns do matter, but for comparative purposes, we need to give these numbers more meaning by actually comparing them.

If you beat all mid-cap stock funds but all mid-cap stock funds fail to beat the market, your crown doesn’t mean much, in fact it is worth less than zero because it serves no purpose other than to attempt to prop yourself up by way of deception. We may not even want to invest in mid-cap stocks at all depending on how they measure up, and they will have to beat the large caps before they should even be in the conversation.

Many investors will willingly pick strategies that are clearly inferior but they harbor a hope that someday their ship may come in, where the world magically becomes inverted and the smaller caps will take over and be the better choice.

There are good reasons why big caps are king, with the biggest one being the fact that this is where most of people’s money gets put. If laggard funds do ever take over, where the probabilities swing in their favor, then this would be the time to go with them. Approaching our investments like we are playing the lottery is a bad idea, but at least with the lottery, our long shots will pay big, as opposed to long shots with only a potentially small payoff. Investing in underperforming funds is clueless all the way around.

78% of actively managed mutual funds fail to beat the market, and in spite of this being fairly common knowledge among those in the industry, the fact that there are still so many of these inferior funds out there tells us that not everyone has gotten the memo.

People put a lot of trust in their investment advisors, and are not unlike patients that go to see the doctor, as they will usually just take whatever prescription that is offered to them without much question. Fund companies also rely on marketing to look to sway investors, and things like your fund has beaten 99% of its peers over the last 5 years does play well in this arena, and people can be fooled pretty easily by such things.

How does Hogan’s fund stack up against the market over the last 5 years or over any time frame? We can start with their 5-year return because this is the one that he has beaten the 99% of his peers with, but we’re going to compare with the big peer, the market.

While investment managers should not be so satisfied with just keeping up with the market, as what we should be doing instead is comparing ourselves with all of the competition, the ones that beat the crap out of the market including the ones that barely beat it, but you have to achieve this first step first, getting on the right side of minimally sensible by beating a random selection.

The Results of This Fund Stinks, Even Though They Try to Mask the Smell

The FAM Dividend Focus Fund has returned a total of 45% since January 2015. Over the same time period, the S&P 500 is up 54%. It is not that the FAM fund has embarrassed itself all that much, but this is well below the market and it’s going to require some real rationalizations for them to even continue to do what they do, perhaps like a sports team tells people that we’ll do better next time after a defeat. The ones that do not even realize that they lost these games are in an even worse spot though.

Given that this performance over this time period is what is being lauded, and the article doing this ended up sounding a little apologetic about other time frames, if this is their best, it is simply not even close to being good enough. Past performance does not guarantee future results but over a 5-year period, this is pretty indicative of a performance that has fallen behind enough to warrant deeming the fund a failure at what they seek to achieve.

If we instead look at 10-year results, we see the same thing happening, only on a bigger scale since there is more time for this fund’s disadvantage versus the market to play out.

The FAM fund is up 235% over the last 10 years, which seems impressive enough until you learn that the S&P 500 has grown by 290% over this time. Once again, the fund wasn’t blown away but still has been beaten soundly and consistently, and losing at all in this particular game spells failure.

It turns out that no matter what time frame we look at, this fund might beat other mid-cap blend funds but fails to achieve its most fundamental objective and do what investors pay them to do, which is to beat the overall market. It us up 17% year to date, but the market is up 26% in comparison, so those who chose Hogan’s fund over an index fund have suffered once again.

When you lose, it doesn’t matter so much how you did it, other than when the losing extends over many years, whatever you have been doing just hasn’t worked, whether this was by way of preferring stocks with a certain dividend growth rate or any other criterion.

We should never look to disguise such failures and any discussion of the merits of a fund like this should make them clear. Even if this were the king of mid-cap funds, if we do not realize that mid-caps are by nature inferior investments compared to large caps, at least historically anyway although there are good reasons why this will continue, we may be easily fooled.

This fund has clearly been a failure and there is every reason to believe it will continue to be so given that this disadvantage has persisted. It actually turns out that the investment style itself is both too restrictive and antiquated, and confining yourself to mid-cap stocks which get less love from the market than large cap stocks do makes it much more challenging to beat them, where we exclude stocks which would otherwise present better opportunities.

What is so noteworthy about this example is that while we have asked this fund to stand alongside its real peers and reveal its ugliness, it is being celebrated on Barron’s for its “stellar performance,” with talk about the fund’s “secret sauce” and such. Whatever is in it does need to be kept a secret because it has not been a success at all, and it’s almost unbelievable how this is not noticed.

Apparently, the walls that segmentation create are so high that many cannot even see over them at all. It actually takes screwing up intentionally to have the market beat you this consistently, and in this case, it is intentionally choosing strategies that do not work, and then stick with them regardless of what happens, where the strategy itself takes preference over even the results themselves.

Making dividends a central criterion will also lead to failure because performance and dividend growth do not correlate anymore and just end up casting off better opportunities in favor or inferior ones that fit our model. Further restricting our scope to smaller companies not base upon merit but just because they are smaller further limits us, and when we step back and think about this a little, this is all madness and it’s no wonder this approach does not work.

In the end though when we’re looking at what makes more or less money, the results need to speak to us, and for those who do want to earn more rather than less, underperforming funds like this cannot even be on their list of candidates, at least until it can show that they are worthy. Don’t hold your breath with this one. We may have to pity the other 99% of its peers even more though, and this is an issue not only for Hogan’s fund but for all clearly inferior funds, which should be put out of their misery instead of our insisting on pretending they are a good idea somehow.

Poorly performing funds are alive and well though regardless, and as long as the waters remain as muddy as they are now, where the ugly can be touted right alongside the beautiful, and especially when we accept comparing the ugly with the ugly as meaningful, much ugliness will survive. This does not mean that we have to subject ourselves to these bad decisions though and it should be easy to separate the wheat from the chaff, if we only care to open our eyes a little wider.

Ken Stephens

Chief Editor, MarketReview.com

Ken has a way of making even the most complex of ideas in finance simple enough to understand by all and looks to take every topic to a higher level.