Mutual Funds Ten For 2000
Buy the manager, not the fund. Some folks swear by it. So as ’99 flips to ’00, MONEY presents our fund managers of the decade: 10 individuals who consistently beat their peers—and frequently beat them silly. More often than not, they also clobbered Standard & Poor’s 500-stock index, which grew 403% from 1990 through the end of November 1999. Try measuring it this way: If you started the decade with $10,000 in an S&P index fund, you finished with $50,000. Nice. If you had invested with some of our top 10, you’d have tens of thousands more. Even nicer. We screened performance data for hundreds of fund managers with Morningstar records stretching back to the early ’90s. Then we examined various stock-picking styles (small-cap, large growth, international and so forth) to come up with the best of the best. You won’t find any one-hit wonders in this crew; these are people who deliver year after year. But you will find in each manager a flexible approach to investing that made him or her great in the past — and a great bet for the future. Read on to learn how they did it in the ’90s and which stocks they think could generate equally great returns in the ’00s.
The managers are listed with the cumulative return for their flagship funds; in two cases we pieced together performance at different companies. (The darker portion of each chart represents peer-group performances.) We also recommend some of the managers’ other funds. All fund data are as of Nov. 30; stock data are as of Dec. 17.
Chip Morris
T. ROWE PRICE SCIENCE & TECHNOLOGY
Back at Stanford business school, Charles “Chip” Morris owned shares of Apple Computer just when Microsoft was introducing Windows. An Apple user, he sneered at the new operating system as inferior. The rest, as they say, is history. And he never wants to repeat it: “I’d have had a better perspective from an investor’s point of view if I hadn’t used Apple and liked it.”
Morris learned plenty more once he took over T. Rowe Price Science & Technology in 1991. He was a mere 28 and the fund held a then sizable $190 million. Today he runs more than $10 billion, and his near-decade-long return is 1,089%, or an annualized 32%. “All I did was take a good product and not screw it up,” says the self-effacing Morris, whose favorite accolade (even more than being named the best finance student at Stanford) was being voted class clown at Winston Churchill High School in Potomac, Md.
T. Rowe Price research chief Jim Kennedy, who hired Morris in 1987, is most impressed with the way his boy wonder managed the fund’s spinning growth during the ’90s. “Chip basically reinvented himself,” Kennedy says. “You need a flexible mind and ego to be able to handle that.” One way Morris adapted was to expand his research staff to 10. Another was to move to big-cap stocks he’d have shunned in his earlier days. All the while, adds Morningstar’s Russ Kimmel, Morris took less risk than many of his peers by refusing to make enormous bets on one subsector — like, say, the Internet.
One risk Morris sees in tech stocks is high (in more ways than one) valuations. “Tech investing today is the equivalent of the free-love environment of the late ’60s,” he riffs. “Everyone is running around taking the same drug — buying the same tech stocks — and having a wonderful time and not caring what will happen in a year.”
He keeps abreast of the field’s relentless changes through a self-styled osmosis. “Like a jellyfish,” he jokes, “I bob around from company to company and analyst to analyst, picking up what I can on what’s driving the industry. Every six months I ask: ‘What are the recurring themes? How do I play them?’ ”
One favorite Morris theme: new products. So he owns Parametric Tech, which has introduced software that helps oversee workflows for engineers. Sales should triple to $300 million this year, he says, and the stock trades at 28 times 2001’s expected earnings of $1 per share. Morris also owns Novell, which is rolling out numerous Internet-oriented products this year—putting it on the screen as a Net infrastructure play. At a recent $25, it’s trading at 25 times next year’s earnings. A final name: Cognex, which creates equipment to inspect chips. “There’s no competition,” Morris says. At $33, its P/E is 30.
T. ROWE PRICE SCIENCE & TECHNOLOGY 800-638-5660; www.troweprice.com
John Wallace
OPPENHEIMER MAIN STREET GROWTH & INCOME (THROUGH MID ‘95)/RS MIDCAP OPPORTUNITIES
Think small-cap growth, and you think John Wallace. Nah, you don’t, because you’ve probably never heard of the 45-year-old fund manager, despite what’s indisputably a star-making ’90s record. At Oppenheimer, Wallace drove Main Street Growth & Income to total returns of 229% from 1990 to his departure in July 1995 (vs. 145% for similar funds). Moving immediately to RS Funds, then called Robertson Stephens, he guided MidCap Opportunities to a 152% gain through November 1999, a good 30 percentage points better than other midcap growth funds. Wallace’s cumulative return over the decade has been a rich 731%. And it rockets even higher, to 1,405%, if you bring in his RS Diversified Growth, a small-cap vehicle that has seen a total return of 279% since Wallace started it in 1996.
Wallace had spent the early ’80s in Ecuador, starting a business marketing hats and sweaters. “He had that entrepreneur’s motivation,” says Diane Jarmusz, who hired him at Oppenheimer in 1986. His taste for risk taking led him toward small-name fast-growers, which soon overtook the utilities and convertibles in Main Street G&I. As he trounced his category, fund assets shot from $24 million to $2.5 billion. His only real gaffe: a $20,000 Securities and Exchange Commission fine in 1995 for failing to properly report some personal trades.
Not long after, Wallace moved to RS. There, he trades aggressively (turnover at Diversified Growth is a frantic 400%), and his zest for new names has led to clunkers like Iwerks, an Imax competitor he bought in the mid-$20s and sold at a dollar. “I just fell in love with it and disregarded my own discipline.” More often, he scores on winners like InfoNow, a Web service provider that has bagged him a twelvefold profit.
While Internet names make up a fifth of his small-cap portfolio, Wallace says he regards most as “trading vehicles until they can prove their business models.” He favors telecom names like Startec Global Communications, which sells international long-distance service to ethnic markets in the U.S. and trades at about $22 with no earnings.
Diversified Growth remains relatively small, with $245 million in assets, while MidCap Opportunity has $210 million. That makes Wallace the best-kept secret in our lineup. “It’s amazing to me,” says David Shore, a financial adviser who followed Wallace from one employer to the next with $1.5 million in client assets, “that John’s so undiscovered.”
RS MIDCAP OPPORTUNITIES, RS DIVERSIFIED GROWTH 800-766-3863; www.rsim.com
David Alger
SPECTRA
Whether he’s surveying New York Harbor from his 93rd-floor office in the World Trade Center or tracking the price/earnings multiples of tech stocks, David Alger is not fazed by great heights. So what if eBay has a P/E of 745 times his estimated year 2000 earnings? “These stocks have such high valuations because they’re growing so fast,” says the 56-year-old president of Fred Alger Management. Factor in their tremendous growth rates, he goes on, “and some of these companies aren’t selling at any higher P/E relative to growth than the market as a whole.”
You can argue with Alger about valuation, but you can’t argue with his results. His longest-running fund, the $734 million, tech-heavy Spectra, has blown away the S&P 500 during the ’90s with a cumulative return of 971%, and its 10-year annualized return of 27% wallops the index by almost 10 percentage points. Long a small, closed-end fund, Spectra moved to open-end status only in 1996. But there have been other Alger successes: Alger Growth B has a 10- year annualized return of 20.8%, and Alger Capital Appreciation B, which started in 1993, has a five-year annualized return of 38.6%.
Alger’s approach to investing: “Buy the stocks of America’s fastest-growing and most exciting companies.” And he and his co-managers are killer stock pickers. “They make aggressive decisions quickly, they trade hard, they concentrate holdings,” observes Michael Lipper of Lipper Analytical Services. “And they’re effective in speculative securities, which is the type of security you’ve wanted to be in for this market.” As for Alger himself, well, “David is very willing to take risk and volatility in stride,” notes money manager Michael Holland, who has known Alger since their Harvard days in the mid-1960s. “When he figures the odds are dramatically in favor of taking those steps, he’s got the investment chutzpah to do it.”
Case in point: In 1999, Alger benefited from Net stocks but added even more return by trading holdings such as eBay several times during the year. Today he remains an eBay cheerleader. “It’s misunderstood,” he says. “It’s seen as an auction place—which it is—but it’s really replacing the classified pages of newspapers. It’s probably going to grow much faster for a longer period of time than people think.”
Research is a hallmark of Alger’s shop. While keeping a sharp eye on the broad trends, he benefits from the detail work of 18 analysts, seven of whom focus on tech. The firm has many illustrious alums, including Tom Marsico and Helen Young Hayes (both of whom also appear on this list), and Alger enjoys his reputation as a star-shaper. “It’s not an accident,” he says proudly, “that they are where they are.”
SPECTRA, ALGER GROWTH B, ALGER CAPITAL APPRECIATION B 800-992-3863; www.algerfund.com
Gary Lewis
VAN KÄMPEN EMERGING GROWTH
Van Kampen Emerging Growth could have been called submerging growth in the 1980s, when it routinely trailed the S&P 500. Then came Gary Lewis. His momentum-based buying and selling has consistently produced off-the-chart returns for a fund company not exactly famous for them, and the master technician spent some time with us explaining how his system works.
Lewis and his three co-managers base their moves on the stock screens they run daily at their Houston offices, zooming in on the one- and three-month changes of two key characteristics: earnings expectations and valuations. But there’s really just one direction that counts: up. “Current earnings expectations are already built into a stock’s price, so I’m looking for expectations and valuations to be rising,” Lewis says. “The market rewards a strong stock by giving it a higher P/E, and we want both parts to work in our favor as long as we own a stock.”
So when will he sell? “Drops in earnings are a bad sign,” he answers, “but we really avoid stocks that have falling P/E ratios, when the market no longer pays a company for strong results. That’s the worst situation for a high-growth manager to be in.” That was the situation he found himself in back in 1994, when valuations plunged on retail holdings like Lowe’s and Dollar General and semiconductor holdings that included Sybase and Microchip. The fund lost 7% and Lewis, 46, considers his failure to get out faster his worst mistake: “I didn’t handle it as well as I could today.”
His current portfolio holds about 140 companies, but he’s owned as many as 300 at a time, a figure that Lewis says reflects his “broad-based view” of the market. (Make no mistake, cautions Morningstar analyst Kelli Stebel: This is an aggressive and often concentrated fund. Recent turnover rates have topped 100%, and 60% of its $10 billion in assets are in tech.) All fund managers at Van Kampen were recently told by their corporate lawyers that they cannot discuss specific portfolio moves publicly. The edict clearly peeves Lewis. But his monthly portfolio reports reflect his trades and show that he’s been accumulating shares of Adobe Systems, Broad-Vision and EchoStar Communications. JDS Uniphase, Qualcomm and Veritas Software were his top three holdings at the end of November 1999.
VAN KAMPEN EMERGING GROWTH 800-421-5666; www.vankampen.com
Tom Marsico
JANUS TWENTY (THROUGH ’97)/MARSICO FOCUS (’98-PRESENT)
Tom Marsico’s largest holding, cellular chipmaker Qualcomm, is up more than 630% since he bought it in April, and at $455 a share, its 2000 P/E hovers above 100. Gettin’ nervous, Tom? No way, insists the 44- year-old. “We’re always checking the story,’’ he assures, “but I really believe in this stock.”
It takes a special kind of confidence — and research — to play Marsico’s game. A pioneer of concentrated investing, he steered both Janus Twenty and Janus Growth & Income to 20%-plus annual gains from the time he launched the funds in 1988 and 1991, respectively, to 1997, when he left the company. The tradition lives on at Marsico’s own fund family. Marsico Focus, which rises and falls on fewer than two dozen stocks, is up 45% for the year, while the more diversified Marsico Growth and Income is up 42%. Do the math for Janus Twenty and Marsico Focus, and you have a cumulative return for the ’90s of more than 650%.
Marsico’s ideas aren’t dictated by elaborate buy-and-sell models. Instead, he’s recruited his own posse of eight analysts — competitive types with liberal arts backgrounds who are encouraged (in the spirit of creative conflict) to cover the same companies. Although Marsico was born, raised and educated in Colorado, a cowboy he ain’t. To dampen volatility, he casts across many types of stocks. While he devotes 15% of each portfolio to ultra-aggressive bets, like Qualcomm, 25% is earmarked for companies going through “life-cycle changes or restructurings”— some might even call them value stocks.
Take Four Seasons. Marsico bought it after 1998’s Asia collapse, when its market cap sank to $500 million—the value of just one of its hotels. Its share price has tripled to $52 and its P/E is 28, but Marsico’s holding tight. “Eighteen projects are planned over the next three years,” he says.
The final 60% of assets go into core growth companies such as top-five stalwart Citigroup, at $54 and a 17 P/E. “This kind of company,” Marsico explains, “lets me sleep at night.”
MARSICO FOCUS, MARSICO GROWTH AND INCOME 888-860-8686; www.marsicofunds.com
Sig Segalas
HARBOR CAPITAL APPRECIATION
According to Merrill Lynch’s employment exam, Spiros “Sig” Segalas, proud bearer of a freshly printed econ degree from Princeton, should have become…an artist. Segalas ignored the advice, becoming instead one of the greatest fund managers of the past few decades. “All I ever wanted to do,” the 66-year-old says with a shrug, “was make money.”
And how. His $7 billion Harbor Capital Appreciation has rewarded shareholders with 22% annual returns since 1990 vs. 17.6% for the S&P 500. That means if you had entrusted Segalas with $10,000 back then, it would be worth $74,000 and change by now. Sticking to a 60-company portfolio of fast-growing big names, he maneuvered skillfully to skirt meltdowns like Compaq (he was skeptical of management’s plans) and ride high fliers like Cisco. “He knows what he’s looking for,” says Ken Gregory, who chose Segalas and four other stars to co-manage his Masters’ Select Equity fund. “He doesn’t get whipsawed.”
Segalas, the New York City-born son of Greek immigrants, made his first successful stock pick straight out of college. His contractor father gave him $1,000 as a graduation gift, “which to me was like a million,” he says. “Though I never smoked in my life, I read in Barron’s that RJ. Reynolds was coming out with the first filter-tip cigarette, called Winston. I bought the stock, it went up by half, and I got the bug.”
His instincts, backed by bottom-up, fundamental analysis, have served him throughout his career, leading him in the 1990s to favor technology stocks (recently 35% of his portfolio) and telecom (another 10%). Though a small stake in AOL is his only outright Internet play, he expects that to change. “No one had heard of networking 10 years ago, and today Cisco’s my biggest name. To keep beating everyone— and that is my job—you have to evolve.”
So how long does Segalas expect to keep evolving—and managing money—himself? “What would I do if I retired?” he answers. “I’m having too much damn fun.” Among his picks going into the next decade is Hewlett-Packard ($105; P/E 31). The struggling tech giant is “not a gimme,” he concedes, but new CEO Carly Fiorina has solid plans. NTL ($112; no earnings) is a company that sells cable and phone services in the U.K. and plans to offer Internet connection. Then there’s Tiffany (about $80; P/E 52). The famous blue box makes this a “stealth Internet play,” Segalas says. “What other brand would you trust to buy jewelry online?”
HARBOR CAPITAL APPRECIATION 800-422-1050; www.harborfund.com
Bill Miller
LEGG MASON VALUE TRUST
William Miller III, a thoughtful fellow with traces of North Carolina in his accent, realized during the 1980s and ’90s that he had to loosen his stringent approach to value investing. Traditional yardsticks, such as P/E and price-to-book ratios, are fine when measuring a world that hasn’t changed since a young Warren Buffett had a finance professor named Ben Graham. “But you can’t have static rules in a dynamic world,” says Miller. “Value investors ignored the technology sector because it changes too much.” Consider the thinking that led Miller to add Dell to his portfolio in 1996, when it traded for a split-adjusted $1. The market had decided that the personal-computer business had become commoditized: The box was worthless, while the chips and software that went into PCs were precious. Miller asked himself: “What are the characteristics of a commodity business?” Since a commodity is all about price, the company that makes it cheapest has the edge. And usually just a few competitors dominate the market. At the time, there were many computer makers around the world, and the largest (Compaq) held a mere 8% market share. Miller saw that Dell was the most efficient maker of PCs and bet it would end up as one of the few carving up the market. Today it is the world’s No. 2 player, with a 14% share, and its stock is trading at about $45.
Don’t think the Dell experience (or his famed purchase of AOL a few years back, or more recently Amazon) has turned Miller into some kind of growth guy. After all, he bought those tech stocks when few wanted them. “It’s not about what will happen over the next 12 months that counts,” he says slyly. “It’s what will be evident to the masses in 12 months.”
Such insights have helped Miller beat the S&P nine years running. Now he’s looking again at the traditional value measurements: “Their time may be at hand.” He’s focusing on such shunned areas as supermarkets (Albertson’s), and he’s stubbornly loading up on some of the names in his 40- stock portfolio that have been crushed recently (hey, even Miller’s not infallible). He suggests Waste Management, recently trading at $14.50 with a P/E of 9; Bank One, at $30 with a P/E of 8.5; and Mattel, at $12.50 with a P/E of 12.
And now the best news: Miller is unveiling a new fund, Legg Mason Opportunity Trust, that will hunt for deals among smaller companies. Call it a leaner, meaner version of his $11.6 billion flagship fund.
LEGG MASON VALUE TRUST, LEGG MASON OPPORTUNITY TRUST 800-511-8589; www.leggmasonfunds.com
Richard Weiss
STRONG COMMON STOCK
It seems every profile of quirky Richard Weiss mentions his ostrich-skin boots or his lucky elephant-hair bracelet (and uses the word quirky). So let’s take you straight to his stock picks—the stuff that has helped the 48-year-old manager of Strong Common Stock deliver one of the best 1990s records around.
Bookseller Barnes & Noble is down to $21 (about four times earnings), and the growth of competitor Amazon is slowing. At B&N’s current price, he estimates, investors are paying $8 a share for its bricks and mortar and $13 for its dotcom.
The leading maker of power-surge protectors, American Power Conversion has a 70% market share and 20% to 25% projected earnings growth, he says. Just one major analyst follows it, and at $28 the stock trades at about 20 times earnings.
PanAmSat, at $50, is worth $60 a share, Weiss figures. The largest commercial satellite company has seen a string of failed launches (which were not its fault, he says), but it has six more satellites set to go next year. Demand is huge and getting huger, as media channels continue to expand.
“I look for quiet areas of the market, where stocks are underfollowed by Wall Street analysts,” Weiss says. He’s a value guy, for sure, but he also likes strong cash flow and earnings prospects, which at times leads him to pay higher prices and even to scoop up the occasional Internet stock. “Weiss has been so successful because he has a well-defined stock-picking discipline combined with flexibility,” says Morningstar analyst Emily Hall. “He’ll revise his private market value based on market events.” After AT&T’s purchase of TCI, for example, Weiss hung on to his soaring telecom and cable stakes, which helped boost his performance.
In 1999, especially, Strong Common Stock was on a tear, fueled by Weiss’ telecom and cable holdings, such as high fliers Media One and NTL. Performance was also boosted by Internet stock DoubleClick, which Weiss purchased during the October 1998 tech debacle at about $10 a share (it recently traded at almost $197). He has trimmed back those holdings, however, as the stock prices have soared. “The market has reached such an extreme in valuation that it will inevitably shift back,” Weiss cautions, “and then small and mid-size stocks will be a good place to be.”
Shareholders who are lucky enough to be in $1.4 billion Strong Common Stock, which is closed to new investors, already feel that way. New investors can choose the $2.4 billion Strong Opportunity, which buys slightly larger stocks. Its return for the decade: an S&P-beating 417%.
STRONG COMMON STOCK (closed), STRONG OPPORTUNITY 800-368-1030; www.estrong.com
Helen Young Hayes
JANUS WORLDWIDE
It’s past midnight, and Laurence Chang returns to his hotel room, flips open his laptop and whips off an e-mail to his far- flung colleagues at Janus Worldwide. Before he can raid the mini-bar, the messages pour in. “There were about seven of us logged on after midnight on a Tuesday,” Chang marvels. Hardly unusual, if you’ve been groomed by Helen Young Hayes. Since she began running Janus Worldwide in late 1992, Hayes has generated 25% average gains for the now $28 billion fund, ushering it to the top 2% of its global category. Returns like that are the product of frequent overseas trips, painfully detailed earnings models and, yes, lots of late-night e-mail. “Helen just demands in-depth, detailed research,” says Chang, whom Hayes hired in 1993 and named co-manager last year. Adds former boss David Alger: “She was probably the hardest-working person to ever work here. I don’t think she ever went home.”
While her investments span different countries and industries, they have a few things in common: They’re market leaders, they have extremely strong management, and they have virtually unlimited potential for growth. Take top 10 holding Nokia. It’s believed that eventually more people will tap into the Internet via cell phone than through a PC, and Hayes and her crew are convinced that Nokia will lead that revolution. There’s a similar story in China, where it’s actually easier to sign up for cellular service than to get on the waiting list for a traditional phone. China Telecom not only meets Hayes’ high standards for management, it serves more than 30% of wireless customers in China. Even better: It has 90% market share in the provinces where it’s available.
JANUS WORLDWIDE 800-525-8983; www.janusfunds.com
Wallace Weitz
WEITZ VALUE
Wally Weitz is no Warren Buffett—and that’s a good thing. True, his down-to-earth manner and value bent (as well as his articulate pronouncements) often call to mind his more famous Omaha neighbor. But Weitz piles in where Buffett won’t, especially into racy cable and telecom stocks. Over the past decade, in fact, more than 40% of his $2.6 billion Weitz Value fund has been stashed in such winners as Liberty Media, Centennial Cellular and McCaw, catching them well before they turned into doubles and triples. “I don’t mind concentrating in a few areas, if that’s where the values are,” says Weitz, who has led his fund to a superb 18.2% average annual return over the past 10 years, placing it among the top 2% of its midcap value peers.
In essence, Weitz’s stock-picking methodology is to determine what a rational business person would pay for the entire company—and buy the stock when it’s well below that value. “That way, if it doesn’t work as a stock, maybe a rational person would try to buy the business,” says Weitz, 50. “I’m not looking for a takeover, but the underlying truth will come out.” His key measure for determining a business’ worth: the present value of the future stream of free cash flows. “For companies that take on a lot of upfront debt, such as cable stocks, traditional measures such as price-to-earnings obscure their value. Whether a large amount of debt is bad depends on the business.”
With the big run in cable stocks mostly over for now, Weitz is on the hunt for his next top performers. “I haven’t found them yet,” he says. Meanwhile, he’s adding to his stakes in financial companies. Countrywide Credit is down to $25.50 on what he calls overblown fears that higher interest rates will dampen its income. Its 2000 P/E is a paltry 7. Host Marriott is going for about $8, yet the real estate investment trust’s property’ values alone are worth $13 a share, he says.
Roughly 20% of the fund’s portfolio remains in cash. “Things happen so fast,” Weitz explains, “and the next big buying opportunity may come and go very quickly.”
WEITZ VALUE 800-232-4161; www.weitzfunds.com
THE NEW FORCE IN FUNDS
A NEW KIND OF FUND IS COMING ON STRONG—OFFERING INVESTORS EASY TRADING, ROCK-BOTTOM COSTS AND MORE CONTROL OVER TAXES.
BY PAT REGNIER
PHOTOGRAPH by MICHAEL LLEWELLYN
NOT SO LONG AGO, you had two basic options if you wanted to play the stock market. You could write a check to a mutual fund and get instant diversification. Or you could take the time and trouble to build your own portfolio of individual stocks, which would let you trade to your heart’s content and control your tax liability. You had a choice between simplicity and flexibility—you just couldn’t get both. And then along came a Spider.
The Spiders, introduced in 1993 to track the S&P 500 index, heralded the arrival of a new type of investment vehicle called exchange-traded funds (or ETFs). They perform almost exactly like a traditional mutual fund, but they can be bought and sold instantly, just like a stock. With relatively little marketing behind them, Spiders and their ilk have already captured more than $20 billion in assets. And if you haven’t considered buying one, you may soon: Barclays Global Investors—the second largest investment shop in the world, with almost $700 billion in assets-—is launching a line of exchange-traded funds, dubbed iShares, that it hopes will be a major competitor to the traditional fund. The company plans to offer as many as 51 new index portfolios that will track almost every conceivable slice of the U.S. market. (Barclays Global Investors, which used to be the investment arm of Wells Fargo, essentially invented the index fund back in 1971.)
Could these new funds be the “killer app” that knocks mutual funds off their perch? Maybe. Can they make life easier for you? Definitely. Indeed, exchange-traded funds may be the best thing to happen to individual investors since Jack Bogle launched the Vanguard 500 Index fund in 1976. ETFs’ most obvious selling point is that they let you trade in and out of the market or a particular sector as fast as you can point and click on your online brokerage account. (You can even short them or buy them on margin.) “If it’s 10 a.m. and you want to buy or sell, you can find out the index price and get that price,” says Lee Kranefuss, CEO of Barclays’ individual investor group. “You don’t have to wait for the market to close.”
But if they work as advertised—and we’ll explore that question in a moment—they should be a boon even for dedicated buy-and-hold fund investors. Since all of the products Barclays plans to launch later this year will be index-based, they will have extremely low management fees. They will also allow you to fine-tune your asset allocation: Many will track indexes that no mutual fund has followed before. Finally, their structure should make them extremely tax-efficient.
If these new-style fluids catch on, even investors who stick to traditional funds could turn out winners. “The mutual fund industry is ripe for reinvention,” notes Don Phillips, CEO of the fundtracking firm Morningstar. “The cost of owning stocks has plummeted, but the cost of owning funds has remained stubbornly high.” Some competition may finally change that equation.
THE MUTUAL FUND INDUSTRY IS RIPE FOR REINVENTION. COSTS ARE TOO HIGH AND PERFORMANCE MEDIOCRE.
SPIDERS, WEBS AND QUBES
Wait a minute: Aren’t there already plenty of funds that trade on exchanges, namely closed-end funds? Yes, but ETFs differ from closed-ends in one crucial way. Closed-ends have a fixed number of shares; depending on investor demand, they can trade at a premium or a discount to the total value of the stocks in their portfolios, or net asset value (NAY). Mostly, they’ve traded at a discount, which is why closed-ends have been a bomb with ordinary investors.
The exchange-traded funds have gotten around that problem. Specialists at the American Stock Exchange, as well as large institutional investors known as arbitrageurs, issue shares when there are more buyers than sellers and redeem shares when there are more sellers than buyers. That should keep the price of the funds at or near their net asset value.
This system also gives the funds a tax advantage. ETF managers give the specialists stock, not cash, to meet redemptions. Thus the fund incurs no tax liability when shares are redeemed, and investors who don’t sell aren’t stuck paying tax bills generated by those who have flown the coop.
The original Spiders, or SPDRs (for Standard & Poor’s Depositary Receipts), were the first products to adopt this innovative exchange-traded format. Since the 1993 launch of the Spiders (they are run by State Street Bank & Trust), 30 new ETFs have popped up on the Amex listings. Best known are the Internet heavy Nasdaq 100 Trust shares (called Qubes because the ticker symbol is QQQ), and WEBS, managed by Barclays since 1996, which track individual foreign markets from Japan to Austria. Other exchange-traded products include Select Sector Spiders, which track various industry groups in the S&P 500, such as energy stocks or financial services; a Spider that tracks the S&P MidCap 400; and Diamonds, which mimic the Dow.
Thanks in part to the wild success of the Internet-heavy Qubes, assets in ETFs have more than doubled since the summer of 1998. That fact, plus Barclays’ announcement of its iShares, has the fund industry buzzing. Bob Turner, chairman of the Turner funds, says this threatens “everybody who hasn’t outperformed the market after taxes and after fees—and that’s a pretty big group.”
BUT WILL THEY WORK?
For these upstarts to take away a big chunk of the traditional fund business, the new products will have to prove that they can keep costs low and reliably trade at NAY. In theory, neither should be a problem. In practice, things might prove a little more complicated. Take costs. Spiders charge 0.18% a year, the same as the Vanguard 500 Index fund. (Barclays won’t discuss the pricing of its new funds, but it has already launched a similar product in Canada that charges just 0.15%.) The only hitch is that you have to pay a brokerage commission every time you buy or sell shares of an ETF. Of course, that cost should be negligible for buy-and-hold investors.
What about NAY tracking? In all but some exceptional cases—notably Malaysia WEBS, after Malaysia imposed currency controls—the prices of ETFs have so far tracked closely to NAY. But Gus Sauter, manager of the Vanguard index funds (perhaps the ETFs’ chief competitors), thinks that ETFs could break down during a panic. He points to what happened on 1987’s Black Monday: “If you had sold S&P 500 futures during the ’87 crash, they were at a 10% discount. I liken ETFs to futures because they rely upon the same arbitrage mechanism. If exchange-traded funds had been around in ’87, they would have been at a 10% discount too.” Barclays’ Kranefuss counters that Sauter is “drawing a parallel between two things that use arbitrage, but in totally different markets.” The fact is, though, that any investment may not perform as intended during market panics.
A SHARPER KNIFE
In the final analysis, there’s a lot to like about the newcomers and not much to worry about. They stand to make fund
investing more efficient than it’s ever been. Of course, even efficiency has its downside. A good sharp knife is faster in the hands of a skilled cook but also makes it easier for a klutz to slice off a finger. Likewise, exchange-traded funds can make smart long-term investing easier and cheaper—but they will also let you do a lot of pretty dumb things, like day-trading funds until your brokerage costs and taxes eat away your gains. But Morningstar’s Phillips, a well-known advocate of buy-and-hold fund investing, says that’s not a fair criticism. “It’s two different things, what you create and how people might use it,” he says. “The same thing has been said about nearly every innovation in the fund industry, from 800 numbers to 24-hour fund information.” True enough. ETFs are not a substitute for smart strategy or sound investment principles. But they just may be a better way to invest.