THE BEST FUNDS FOR THE FUTURE TO FIND TOMORROW'S TOP FUNDS, YOU NEED TO CHOOSE YOURS THE WAY PROS PICK STOCKS. HERE'S HOW WE DISCOVERED 10 GREAT ONES.
(MONEY Magazine) – Earlier this year, as MONEY prepared to look back on 25 years of fund investing--starring such luminaries as Peter Lynch of Fidelity Magellan, John Neff of Vanguard Windsor and John Templeton of Templeton Growth--my editors asked if I could figure out which fund managers will be the superstars in the next 25 years.
My first answer was no. I firmly believe that the time for picking funds based primarily on their past performance is gone forever. As we'll see in a minute, there's good reason why every fund prospectus warns that past performance does not predict future results: because it doesn't.
But then I recalled that homily you see in every greeting-card store: "Grant me the serenity to accept the things I cannot change, the courage to change the things I can and the wisdom to know the difference." Cliche though it may be, it's a good thought for investors to live by. Because above all else, successful investing is about controlling the controllable. This story, at heart, should help give you the wisdom to know the difference between what you can control and what you can't.
Your fund manager's returns are not controllable (they're not even predictable). But how much you pay in expenses, how he invests, how he shares his management duties and how he treats customers like you--in short, how he runs his business--are controllable.
The evidence is overwhelming that funds with superior past returns do not sustain them for long. In a damning study in the Financial Analysts Journal two years ago, Ronald Kahn and Andrew Rudd of Barra, a respected investment research firm, analyzed the returns of 300 stock funds from 1983 to 1993 and found "no evidence of persistence of equity fund performance." In other words, yesterday's winners were tomorrow's losers (and past losers, alas, did not become future winners). So instead of obsessing about past performance, I believe you should choose funds on the basis of five factors you can control.
LOW COSTS. Unlike future returns, your fund's annual expense ratio is knowable. It's printed on the first pages of every prospectus. And it reduces your return penny for penny. On average, over time, funds that charge higher expenses will make you less money than funds with low expenses will. No wonder, when recently asked how people should select a fund, Nobel-prizewinning economist William Sharpe replied: "The first thing to look at is the expense ratio."
And thus each of the funds we highlight here has dramatically below-average expenses: All the U.S. stock funds in this article have annual expenses of less than 1.25% of assets; our international stock funds have expenses of less than 1.6%; and our bond funds charge no more than 0.75%. That alone makes all these funds good bets for the future.
HEAVY INSIDER OWNERSHIP. Great stock pickers like Warren Buffett love companies whose managers invest heavily in their own stock. Why would anyone choose a mutual fund any differently? "We really do invest as if the only money we manage is our own," says Chris Browne, co-manager of Tweedy Browne Global Value; he and his partners have more than $40 million in their two mutual funds.
Insider ownership isn't just good for the warm fuzzies. When the manager owns a lot of his own fund, he's less likely to do things that run counter to your best interests, since they'd be against his too. He won't charge exorbitant expenses, take giant gambles or feel compelled to trade so much that he generates a huge tax bill.
Also, insider ownership is your best defense against what I call the fatso fund problem. Funds that grow too big too fast may be forced to buy too many stocks at too high a price (MONEY, April 1996). But because big funds make more money than small ones for the companies that run them, many portfolio managers get bonuses when their funds grow larger--meaning that the managers are rewarded for acting against your best interests. Only fund managers who own a lot of their own shares have a strong incentive to limit asset growth. Listen to Chris Davis of Selected American Shares, whose family has more than $500 million in their mutual funds: "We know we'll close any of our funds that get too big, because it's our money in there. We earn a lot more from 1% better performance than we do from bringing in 10% more assets."
TIGHT FOCUS. In a fairly efficient market like the U.S., the more stocks a fund owns, the more likely it is to produce returns similar to those of the market averages. Over time, a domestic stock fund that owns 200 or more companies, as many do, will end up looking a lot like Standard & Poor's 500-stock index. To beat the market, a fund has to do something different. That means either owning fewer stocks, or owning a lot more of some stocks, than the market as a whole; it might even mean owning some bonds or foreign stocks. That flexibility is what made a legend of Peter Lynch. In 1982 he had 5% of Fidelity Magellan in "risky" Chrysler stock, and his single biggest position was in Treasury bonds; in 1986 he put 20% of his assets in foreign stocks.
Listen to Susan Black, co-manager of Warburg Pincus Capital Appreciation, which owns just 65 stocks vs. 123 for similar funds: "If you don't want to just mimic the averages, then you want to put your money only in the most attractive companies."
A GOOD BENCH. At the N/I funds, lead manager John Bogle Jr., 37, and president Langdon Wheeler, 50, don't take the same flights if they can avoid it. "To ensure continuity of management," says Bogle (son of John Bogle, founder of the Vanguard funds), "we don't want to both die in the same plane crash." At Acorn International, top manager Leah Zell is backed by seven research analysts. Loomis Sayles Bond manager Daniel Fuss is bolstered by associate manager Kathleen Gaffney and backup managers John de Beer and Fred Vyn.
A SENSE OF BELONGING. No, I haven't been blissing out on New Age music. This really is important: Every fund investment should be a partnership between you and the portfolio manager. "I go to bed every night praying my shareholders understand there's no quick way to get rich," says Zell. She hammers that message home at Acorn's annual meetings, which hundreds of shareholders attend. At Longleaf Partners' yearly gatherings, Mason Hawkins addresses his customers as "partners." Acorn, Longleaf, Oakmark and Tweedy Browne all send their shareholders homey reports full of investment wisdom. By reaching out to you, these funds raise the odds that you'll stick with them if times get tough, which is good both for them and for you.
Now, here's my summary of the funds for the future. Each one has excellent performance, but it's the other qualities I've mentioned that make them even better bets for the next quarter-century. (As a bonus, none carry a sales load.) First come U.S. stock funds, then international stock funds, then bond funds; for key performance and portfolio data, see the table above. And, yes, I've included two index funds; although they lack some of our qualities, such as tight focus and a sense of belonging, they offer the controllable virtues of low cost and high predictability.
Longleaf Partners Realty. This specialty fund is the last way to join Hawkins, 49, the value investor extraordinaire who has closed his other two funds until stocks become cheap enough for his taste. Since its birth at the start of 1996, Longleaf Realty has returned an annual average of 40.3%, thanks to stocks ranging from IHOP, the chain of breakfast restaurants, to Pioneer, the mutual fund firm that owns a gold mine in Ghana. Hawkins and co-managers C.T. Fitzpatrick, 33, and Staley Cates, 33, buy stocks at what they believe to be 60% or less of their value. Why so picky? Hawkins and his associates own $130 million worth of their own funds.
N/I Growth & Value. Its siblings, Micro Cap and Growth, closed to new investors in August, but this fund, recently with $50 million in assets, will stay open until it hits $200 million. Bogle, Wheeler and research head Mark Engerman, 29, snap up stocks with rapid earnings growth and rising expectations on Wall Street, along with shares their computers tell them are cheaper than usual. They trade more rapidly than our other picks, owning their typical stock for about six months, but the fund is up a yearly average of 36.2% since its launch in June 1996.
Oakmark. With an annual average return of 30% since its 1991 launch, Oakmark has outperformed 99% of all U.S. stock funds. What's more, it has cut its expenses by more than a third since 1992, has owned its typical stock for more than four years and has kept its $6 billion portfolio zeroed in on about 50 big and mid-size stocks that trade below manager Robert Sanborn's appraisal of their value. "I want at least two-thirds of the assets in the 20 stocks I know the best," says Sanborn, 39. As assets rise this year, expenses should drop below their current 1.1%.
Selected American Shares. Manager Chris Davis, 32, is the third generation of the Davis dynasty of value investors: His grandfather Shelby Cullom Davis made a fortune investing in insurance stocks a half-century ago, while Chris' father Shelby steered Davis New York Venture fund to more than 20 years of consistent results. Selected American also concentrates its bets, shoveling its $2 billion in assets into just 75 stocks. "I'd like to have 80% of the assets in just 30 stocks," says Davis. "It's easier to name your 30 best friends than your 100 best friends." Among his recent intimates: Halliburton, IBM and McDonald's.
Vanguard Index Total Stock Market Portfolio. This $5 billion "passive" portfolio may seem an odd fit here. But its virtues are very reliable: Skipper Gus Sauter, 43, and his team simply make sure that the fund mimics the return of the Wilshire 5,000 index of 7,349 stocks. Up an annual average of 25.7% over the past three years, Total Stock Market has rock-bottom expenses (0.22% a year) that practically guarantee it will outperform more than half of all other funds over long periods of time; it is highly tax efficient, allowing investors to keep more than 94% of what they earn; and it offers broader exposure to the market than Vanguard's Index 500 fund.
Warburg Pincus Capital Appreciation. Co-managers Black, 57, and George Wyper, 41, tend to hold a concentrated basket of five or six dozen small, medium or large stocks that represent "growth at a reasonable price"--in other words, rising profits and a moderate price/earnings ratio. Black likes growth stocks, Wyper likes value; both seek companies whose bosses are managing capital wisely by buying back shares or snapping up other firms cheaply. The $585 million fund has returned an annual average of 27.9% since Wyper and Black took the helm in late 1994.
Acorn International. Lead manager Zell, 48, rustles up fast-growing small stocks in some 40 countries outside the U.S. She looks for firms that can benefit from sweeping changes like technological innovation, financial reform and higher leisure spending. With too much money coming in too fast, the fund closed to new investment in early 1994--just before overseas markets crashed--and reopened when they got cheap again in late 1995. "We don't spend shareholders' money on gathering assets," Zell says. "We spend it on doing good research and hiring the best people we can find."
Tweedy Browne Global Value. Co-managers John Spears, 48, and brothers Chris Browne, 50, and Will Browne, 52, search the global investing graveyard for stocks other money managers have left for dead. A typical Tweedy stock sells at 74% of book value, roughly three times less than the average stock worldwide. The managers have more than $40 million in this fund and its sibling, American Value. Only about 15% of the $1.9 billion portfolio is in the U.S.; the rest is strewn from Belgium to New Zealand, with big stakes in Japan (19%) and Switzerland (13%). The fund reduces risk by hedging its foreign currencies and capping individual stock positions at 3% of the portfolio.
Loomis Sayles Bond. Fuss, 64, de Beer, 58, and Gaffney, 35, cook the spiciest bond goulash around. Among the recent ingredients: debt issued by New York City's Rockefeller Center, a South African electric utility, the government of Poland, California's recently bankrupt Orange County, skivvies maker Fruit of the Loom and, of course, the U.S. Treasury. But Fuss knows what he's doing: He has outperformed 99% of all other bond funds since launching in 1991.
Vanguard Index Total Bond Market Portfolio. As with Vanguard's stock-index funds, here too you get high predictability of performance at microscopic cost: Co-managers Ian MacKinnon, 49, and Kenneth Volpert, 37, have whipped 71% of all their peers over the past three years. By keeping costs low and using their computers to capture tiny inefficiencies in the bond markets, the Vanguard managers should continue leading the pack.
At each of these funds, past performance has been topnotch. But far more important, the people who run them have a coherent investment philosophy and a way of doing business that should make you proud to join them as partners long into the future, whatever the markets bring. I'm convinced that's the best way for you to invest over the years to come.