Special Report -- Mutual Funds
Our Annual Guide to Mutual Funds
Big gains count, but so does risk, in our yearly guide to the best equity funds
What makes a great mutual fund? High returns, of course. And on that count, 1999 produced a bumper crop of winners: 157 equity funds posted gains of 100% or more, 18 broke the 200% barrier, and two beat 300%. Sure, we're impressed. But are these really the best funds?
Many of those returns came by taking big risks, such as investing in spanking new dot.com outfits or in small Japanese companies. Over the past year, the funds that took those risks were more than amply rewarded. But mutual-fund investing is more than a one-year proposition, and it remains to be seen if those stellar results can be maintained over the long haul--or even through 2000.
To help you get a broader and more in-depth look at fund performance, we bring you the BUSINESS WEEK Mutual Fund Scoreboard. This 15th edition of the Scoreboard, prepared for BUSINESS WEEK by Morningstar Inc., draws on a database of nearly 3,000 equity funds.NITTY-GRITTY. That's not every single fund. For funds with multiple share classes, we only report on the largest. And we screen out institutional funds unless they're available to individual investors through one of the mutual-fund supermarkets, such as those operated by Charles Schwab & Co. and Fidelity Brokerage Services. And we do not put a fund in the Scoreboard until it has been running for at least one year.
The Mutual Fund Scoreboard contains a trove of data. We have total returns, both pretax and aftertax, for the past year, plus the three-, five-, and ten-year periods where available. We look inside the funds' portfolios, and report on the cash level, price-earnings ratios, turnover, and largest holdings. There are also the nitty-gritty operational data, such as assets under management, and the sales charges and operating expenses. Next week, the Scoreboard turns to bond funds, and in two weeks, closed-end funds.
The Scoreboard that starts on page 86 has 885 funds. That covers everything from the $104 billion Vanguard 500 Index, which just supplanted Fidelity Magellan as the largest fund (table), down to Kemper New Europe M, with just $259 million. Those funds account for about 95% of the assets of all our Scoreboard funds. Visit our Web site, www.businessweek.com, and you'll find those, plus over 2,000 more, in an interactive version of the Scoreboard. If you're not familiar with the online Scoreboard, you should be. The returns--and the ratings--are updated every month.
The highlight of our Scoreboard, both in print and online, is the BUSINESS WEEK rating. We don't rush to judgment on a fund, even if it has produced dazzling results of late. Look at Lexington Troika Russia Fund, which gained 159.8% last year after losing 83% in 1998. If you had bought the fund at the beginning of 1998, your account would have to gain another 56% before you would break even. That's why we wait to see five years' worth of returns. We can assess the fund under a variety of market conditions.
But we don't stop there. Those five-year returns have to be adjusted for risk. For each, we look at every month's return and match it against the comparable month's return on Treasury bills. The more often the fund lags behind the T-bill return, the greater the risk adjustment. Similarly, the larger the underperformance, the greater the markdown for risk. After adjusting the returns, we rerank the funds and score them on a curve. The top 12.5% get A's, our highest rating. In the current Scoreboard, which covers 1995 through 1999, 121 funds made the A list (table).
These top-rated funds span a wide range of investment styles and returns. At the high end, there's Invesco Telecommunications Fund, with a five-year average annual return of 46.2%. At the low end: Gabelli ABC Fund, with a five-year average of just 10.4%. Thirty-five of the funds are domestic hybrids, which mix stocks, bonds, and sometimes cash. Such mixes rarely beat all-equity funds when the bulls are stampeding on Wall Street, but bonds and cash do temper month-to-month volatility. That's why hybrids--they often have "Balanced" or "Asset Allocation" in their names--fare well when their returns are adjusted for risk. Every one of the 35 has a very low risk rating.
Large-cap stocks have dominated the market for four of the past five years, so large-cap funds also stand out in the ratings. Thirty-three are large-cap blend funds, with holdings that tend to look a lot like those of the Standard & Poor's 500-stock index. Among A-list funds are nine S&P index funds, and three more "enhanced" index funds that tweak the S&P to squeeze a little extra return: PIMCO StockPlus Institutional, Smith Breeden U.S. Equity Market Plus, and UAM Analytic Enhanced Equity Institutional.
Nineteen are large-cap growth funds, which have soared along with the technology, telecommunications, and health-care stocks they favor. Three of them are index funds as well. Rydex OTC Investors tracks the Nasdaq 100 Index; Vanguard Growth Index tracks the growth stocks in the S&P 500; and Wilshire Target Large Company Growth tracks a segment of the Wilshire 5000. Value stocks are another story. Large-cap value funds, which have trailed large-growth badly for the past two years, accounted for just four of the top funds. One, Legg Mason Value Premier Shares, beat the S&P, and all have beaten their large-cap value competitors between 1995 and 1999.
Thanks to a strong pickup in most global markets, international funds have returned to the A list. Two are world funds, which include U.S. stocks in their portfolios, and two are foreign funds, which do not. Two specialize in European stocks, and one is an international hybrid, mixing stocks and bonds. None of the diversified emerging-markets funds made it to the A list, even though they were up strongly in the past year--72.1%. Because of heavy losses in 1997 and 1998, the long-term results are poor indeed--an average of 4.4% a year over the past five years.
There's little overlap between the funds on the A list and those that earned triple-digit returns last year. Only four funds made both lists: Invesco Telecommunications, Gabelli Global Interactive Couch Potato, Janus Mercury, and Rydex OTC Investors. The Invesco fund was up 144.3% last year and Gabelli, 116.1%, but the other two barely made it over the 100% line.CHECKERED PASTS. Why so few? Only about one-third of them have been around long enough to earn a rating. And many with enough history have a checkered past. Take Warburg Pincus Japan Small Companies Common Shares, which gained 328.7% last year. It lost money in three of the past five years, including a 25.4% loss in 1997. That's the main reason why the fund's rating is still only a D--our second-worst.
Not a single technology fund made the A list, even though tech funds are the top-performing category of funds over the past 1-, 3-, 5-, and 10-year periods (page 82). The high-performance Internet-specific funds within the category are too new to be rated, and the returns of the more seasoned tech funds fall a tad short when adjusted for risk. The best-rated of them is Invesco Technology II, which earned an overall B+ rating, the second-highest. That fund logged a 144.9% return last year and an average annual return of 43.8% over the past five.
Conspicuous in their absence are small-cap funds. Only one, Weitz Hickory Fund, made it to the A list, and it's closed to new investors. There are many worthy funds that don't make it to the A list because their investment style is out of favor. For that reason, we also rate funds against other funds in the same category. Looking for a small-cap growth fund with a history of top risk-adjusted returns? You might consider the Baron Growth, Bridgeway Aggressive Growth, or Fremont U.S. Micro-cap funds, which are among those that earned A's when rated against their peers (table). And contrarian-minded investors might be looking to buy small-cap value funds, which have badly lagged behind the others for the past two years. Our ratings show Third Avenue Value and Royce Total Return to be among the best.
The ratings system treats well-known and unknown funds alike. Fidelity, Janus, and Vanguard funds regularly show up among the top-rated, but so do lesser-known funds such as Warburg Pincus Capital Appreciation Common Shares, Franklin California Growth A, and Bridges Investment funds.
The $1.1 billion Warburg Pincus fund, run since 1995 by Susan L. Black, invests in both large-cap and mid-cap stocks. The fund earned 48.3% last year, with a well-timed boost in technology holdings at midyear. "That's made the fund more volatile than in the past," says Black, "but tech is the place to be." Tech now comprises about 40% of the fund, but Black says she is also broadening her roster to include financial and energy stocks.
For Conrad B. Herrmann, who runs Franklin's California fund, tech is almost always the place to be. The fund's charter says 65% of its holdings must be in companies headquartered in the Golden State, or with major operations there. "When we launched the fund 10 years ago, we never envisioned what would take place here in California with the technological and Internet revolution," says Herrmann. This mid-cap growth fund nearly doubled its shareholders' money last year. Herrmann says the fund, thanks to Silicon Valley, will continue to have a technology tilt. But he is also looking to broaden the fund by adding nontech stocks such as Clorox Co., the household-products company, Robert Half International, a temporary-staffing agency, and even a few utilities and real estate investment trusts.
Tech stocks, especially large ones, have been very good to Edson "Ted" L. Bridges and the $62 million Bridges Investment Fund. His fund gained 36% last year, and among his winners are familiar names like Microsoft, Apple Computer, and 1999's superstar, Qualcomm, which was up twenty-seven-fold. But for 2000, the Omaha-based Bridges is looking to move downscale, buying more small-cap and mid-cap stocks, "where the growth characteristics and valuations are better right now." He also expects the market to be more volatile and vows to "take the money off the table more quickly as the stocks go up."
If only that were a problem for Michael Sandler, co-manager of the Clipper Fund. Clipper, one of the few top-rated large-cap value funds, takes concentrated positions in brand-name, large-cap companies--except if they're in technology. That's largely why Clipper lost money last year, down 2%. Its top holdings--Freddie Mac, Fannie Mae, and Philip Morris--all lost ground last year, especially the tobacco giant, whose price fell 57%. "The irony is that the companies we invest in are doing great on an operational basis," says Sandler.
When funds lose money, they also lose shareholders. Clipper lost 16% of its assets over the past year, but only 2% came from investment losses. The investment return for Oakmark I, once a leading light of the value crowd, was -10.5% last year, but fleeing shareholders withdrew so much money that the fund's size has been halved over the past 12 months.TAX BITE. The combination of negative returns and a shrinking asset base can be painful for investors who stay behind. If the funds need to sell stock to meet redemptions, they may eventually start selling profitable positions. The capital gains generated by those sales are, by law, distributed to the remaining shareholders, and that will trigger a tax bill for those who own the funds in taxable accounts. As bad as the pretax return was for Oakmark I, the tax bite made it even worse, -13.5%. And that's an estimate based on just federal taxes.
You can't always be sure when there are going to be large distributions, but the Scoreboard offers some hints. One clue is flagging returns, the other is asset flight. Check out the column with the header, "% Change." Then look for the "untaxed gains" column on the right-hand page. That's the percentage of the assets that are unrealized capital gains. In general, the higher the number, the greater the gains--and potential for distributions--and taxes.
Of course, many shareholders elude those taxes if the funds are in 401(k) accounts. But every shareholder, taxable and tax-deferred, bears the fund expenses, and you can find them in the Scoreboard, too. For instance, the 2.5% expense ratio for Putnam International New Opportunities B Fund may not have mattered much last year, when the fund gained 103.4%. But expenses are deducted from the fund's assets each year, whether or not the fund makes money. That's why smart investors keep an eye on expenses as well.
Want to know how the funds measure up? Turn to page 86 and read on.By Jeffrey M. Laderman, with Marcia Vickers, in New YorkReturn to top