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Do You Really Want an Active Fund Manager?
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Foster Friess recently showed the power an active mutual fund manager wields over his or her investments. The lead manager for the Brandywine Fund moved two-thirds of the fund's $9.5 billion in holdings into cash.
Putting aside for the moment the question of whether Friess's move was astute or foolish, it does raise the issue of what we're paying money managers to do and what they're doing. I'll bet many of the shareholders of Brandywine Fund thought they were paying Friess to buy stocks, not to time the market.
Freiss, however, would argue that shareholders pay him to manage the fund and by investing in Brandywine, they have said they trust his judgments. It's the price we pay for actively managed funds.
Most of us know by now that investing in a broad-based market index such as the Standard & Poor's 500 is a strategy that's tough to beat. When John C. Bogle, chairman of the Vanguard Group, introduced the first index fund for retail investors in 1976, he was scoffed at for selling mediocrity.
Beating the average is the American way. But Bogle got the last laugh as the Vanguard 500 handily beat most managed funds over the past two decades. Now, there are hundreds of index-based mutual funds that track everything from the S&P 500 to individual sectors like technology or utilities. The funds are designed to track the performance of that group and have little or no management involvement. And you know what? Most of them beat the returns of actively managed funds. The S&P 500 consistently has outperformed four out of every five actively managed funds for the past 20 years.
The S&P 500 by itself isn't a diversified portfolio. But you could look at diversifying through very systematic investment strategies. For instance, you could buy strategy funds like those that invest in the "Dogs of the Dow." The Dogs of the Dow theory is simple. After the stock market closes on the last day of the year, of the 30 stocks which make up the Dow Jones Industrial Average, select the ten stocks which have the highest dividend yield. Then simply get in touch with your broker and invest an equal dollar amount in each of these ten highest yielding stocks. Then hold these 10 dogs for one year. One fund that follows this strategy is the O'Shaughnessy Dogs of the Market.
What to look for in a strategy
So how should we choose active fund managers? A better question might be: Should we really choose them at all? Over the past decade, I've interviewed hundreds of portfolio managers. Only a handful stand out. These are people with a passion for investing. They also have a strategy and the conviction to stick with it. And they aren't afraid to bet big on their hunches.
Jon Fossel, former head of the Oppenheimer Mutual Funds, used a contrarian strategy for investing his 401(k) plan when he joined the Oppenheimer Group of funds as chairman in 1987. He rolled over his $31,000 in retirement money from his former employer and invested it in the two Oppenheimer funds that had been the worst performers in 1987. He also directed all of his 1988 contributions into the same two funds. The result? Over a seven-year period, the average cumulative return was 227.7 percent.
The problem is, people like Fossel are the exception rather than the rule. Investing in a fund managed by someone else is a gamble. You're gambling that he or she is going to stick to the stated strategy as explained in the fund's prospectus. But as Freiss vividly showed, managers can do whatever they want and you're stuck with the results.
What to look for in a manager
If you're going to pick an actively managed fund, consider these issues before choosing:
1. Look at the manager's plan.
What will he do if you give him your money? Michael Price of the Mutual Shares funds is one of my favorites. He's very clear about how he looks for undervalued securities.
And he does exactly what he says. He's not afraid to take a big position in a company and force a showdown with the board, as he did with Chase Manhattan Bank, or even to put one of his team on the board, as he did with Sunbeam. These maneuvers have meant big rewards for shareholders.
I've been a shareholder in Price's funds for many years. Unfortunately, Price is a poster boy for the problem with active funds. When he sold his company to Franklin/Templeton recently, he began untangling himself from management. I won't buy any more of his funds, but for now I'm holding the two I have.
It's important that you understand the manager's plan. Gary Pilgrim of PBHG Growth and Garrett Van Wagoner of the Van Wagoner Funds are what professionals call "momentum investors." They use computer-generated models to find stocks with rapidly growing earnings, which drive up the stock price. When the price takes off, they jump on the bandwagon. Then they try to jump off before it cools down
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2. Look for concentration.
Great managers have courage and conviction. They find the best companies. And then they buy a lot of them. For example, Longleaf Partners concentrates on the 20 or 30 best companies that the managers O. Mason Hawkins and C. Stanley Cates can find. "If we take the trouble to find the best companies, why should we dilute our holdings by investing in the second-best?" Hawkins asked me in an interview.
3. Demand low portfolio turnover.
Every time the manager sells a security at a profit, you have both additional transaction charges and a capital gains tax liability. Under the 1997 tax law, long-term capital gains were given a nice tax cut. Not so for short-term capital gains. That provides an extra penalty for short-term trading.
4. Demand low expenses.
Many fund companies have become arrogant. They have contempt for their shareholders. Some are always looking for new ways to sneak in fees so we won't spot them. Good companies respect their shareholders. They charge reasonable fees. Eighty-five or 90 basis points should be enough to manage a good domestic stock fund. One percent tops.
5. Look for manager ownership.
One reason good funds keep their expenses low is because the managers invest their own money. When I interviewed Hawkins and Cates at Longleaf Partners, they told me they have all of their own money invested in their funds. That made me want to join them.
Picking active managers is tough. It requires considerable time and research, but it's an exercise that can be rewarding - and very important to your overall investment strategy.
6. Consider the fund's size.
Some mutual funds like Fidelity Magellan, the nation's largest, can influence a stock's price by a single purchase or sell order. That puts funds like Magellan under a microscope from federal regulators and other investors. Fund managers need size, but there are drawbacks. As they become larger, the managers have a more difficult time in creating portfolios that don't adversely influence the market. 
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Illustration by James O'Brien Copyright 1998 Microsoft Corporation