By Jason Zweig | May 3, 2017 10:32 pm ET
Image credit: Lynn Pelham, “Salesman Teddy King (L.) trying to sell mutual funds at poolside” (1958), LIFE Photo Collection, Google Arts & Culture
Nowadays, with exchange-traded funds dominating the market, you no longer hear mutual-fund executives bragging that “Our industry, unlike the rest of Wall Street, has never had a major scandal.” But, back in the 1990s, they used to say that all the time. To commemorate the 75th anniversary of the mutual fund, back in 1999, I decided to investigate the historical record. I wasn’t entirely surprised to find that mutual funds had, in fact, created plenty of scandals over the years. And, increasingly, they were straying from the culture of stewardship that had usually — although certainly not always — dominated their industry. In another context, I called mutual funds “the greatest contribution to financial democracy ever devised.” But they often faltered in living up to their promise. By looking back at history, thoughtful people can learn from the mistakes others have made and try not to repeat them. Unfortunately, by defiantly ignoring their own history, mutual-fund executives became smug and complacent. If investors have largely abandoned them, fund companies have no one to blame but themselves.
Here’s the chronicle I wrote in 1999 on 75 years of mutual-fund history. If you like it, be sure to download the PDF versions, where you can view a graphic timeline that gives a sense of sweep and scope to the long growth of a great American industry that ended up losing its way. If fund managers returned to their roots in delivering good service to everyone at a fair price, they still could regain some of that lost greatness, but I wouldn’t count on it.
“Look Back and Learn”
Money Magazine, April 1999
Booms and busts, fashions and binges, have been part of the mutual-fund experience almost since the beginning.
If you want to understand what investing would be like without mutual funds, you need only look back to 1924. In those days, if you were a small investor who wanted your money run by a professional, you had to buy an “investment trust” for more than the value of its portfolio. Then you’d shell out a 10% sales charge and fork over up to 12.5% of your profits for the manager’s annual fees. And your “trust” would probably refuse to tell you what stocks and bonds it held.
All that changed on March 21, 1924, when Edward G. Leffler launched Massachusetts Investors Trust, the world’s first open-end mutual fund. For the first time, investors could sell their shares back to the fund company at any time and at a known price. The minimum investment: just $250, plus a 5% sales charge — all told, only $2.50 less than than the cost of a new, economical Ford Model T runabout.
The fund industry has since gone on to bring nearly 70 million Americans relatively low-cost, low-risk portfolios they could seldom afford (or would rarely dare) to assemble on their own: everything from blue chips, foreign stocks and money-market accounts with free checking to junk bonds and the shares of U.S. companies too small and obscure for most investors to research by themselves. By making investing easy and affordable for almost anyone, funds have given average Americans a stake in the economy that was inconceivable 75 years ago. Funds have helped transform our political democracy into an economic one as well.
But the history of mutual funds is not all sunshine and light — and the past is full of useful lessons. While researching this feature, I was struck again and again by how the booms and busts, the fashions and binges, that have marked recent fund history all have clear precedents in the past — and I was reminded of the old saying, “Every time history repeats itself, the price goes up.” Here, then, are the overriding lessons I’ve gleaned from studying 75 years of fund history.
- Since 1926, when returns were first tracked, the average stock fund has beaten Standard & Poor’s 500-stock index in just 35 out of 73 years. In 28 of those 35 years, small stocks outperformed large ones. And that — not the skills of fund managers — holds the key to beating the market. Since funds have always favored companies smaller than the ones that make up the S&P 500, funds are most likely to beat that index when small stocks do better than big ones. The lesson: Until large stocks slow down, most funds will keep underperforming. If you expect otherwise, you’re kidding yourself.
- In 1966, celebrity manager Gerald Tsai’s new Manhattan Fund raised a then record $247 million. In 1967, Manhattan returned a market-stomping 39.4% — but it went on to lose 76.3% by the end of 1974. From 1991 through 1993, the American Heritage Fund was the hottest in the country, gaining an annual average of 48.9%. Then, over the next five years, it lost 71.2%. More recently, Lexington Strategic Investments and Dreyfus Aggressive Growth, among many others, have flamed out after short hot streaks. The lesson: Before you buy a hot fund, ask yourself how you’ll feel when it turns cold — because it surely will.
- Lately, technology funds have been on fire. The Internet Fund, for instance, was up 196.1% in 1998. But this is the third time tech funds have been hot — and you’d better hope this time works out a lot better than the last two.
- In the 1950s, investors sank hundreds of millions of dollars into funds like Television-Electronics; Atomic Development Mutual; Nucleonics, Chemistry & Electronics; and Missiles-Rockets-Jets & Automation. These funds held such “stocks of tomorrow” as Lithium of America, Pronto Uranium Mines and Consolidated Electrodynamics. Despite the bull market of the 1950s and the U.S. economy’s huge leaps in technology, only a few tech stocks made money, and many went bust. In 1982, tech got hot again. Fidelity Select Technology shot up 38.4%, then 29.9% more in 1983, thanks to stakes in “upstart space-age firms” like Silicon Systems, Watkins-Johnson and GenRad. But the next year, Fidelity Select Technology lost 16.9%; the average tech fund fell 11%. Fifteen years later, even after gaining 51.8% in 1998, tech funds still haven’t caught up with the S&P 500. The lesson: Sector funds have a chronic history of overpromising and underdelivering.
- Every few years fund companies pump out gimmicky new “products” that promise higher returns. In 1968, “go-go” portfolios like Mates Investment Fund produced returns of up to 72% while the S&P 500 gained only 24%. But Mates was loading up on privately issued “letter stock,” then arbitrarily marking up the value of those shares and including the markup in its total return. When the Securities and Exchange Commission put a stop to this stunt, Mates lost 22% in a matter of months. Likewise, in the mid-1980s, giant firms like Putnam and Dean Witter offered “plus” funds that purported to wring extra income out of government bonds. Funds owning bonds with 9% interest miraculously “enhanced” that yield to 11%. Over the next few years, as interest rates dropped, these funds lost billions of dollars. The lesson: Ignore promises of outsize returns and “unique” strategies. Stick to plain funds with understandable strategies.
- An amazing amount of the time, the experts’ forecasts have been wrong. When Vanguard launched its first stock index fund in 1976, Columbia University finance professor Roger F. Murray called index funds “an idea whose time has passed,” and an executive at fund manager National Investors Corp. proclaimed that “indexing is a sure path to mediocrity.” Since then, Vanguard 500 Index has consistently trounced its rivals.
Fund managers themselves are feckless forecasters. One of the easiest ways to measure managers’ views of the future is to count their cash; when funds hold 10% or more of their assets in reserve, they are bearishly waiting for stocks to turn cheaper. When cash is low, at 5% or less, bullish managers have already spent most of it on stocks.
Over time, you can use fund managers’ cash positions to forecast the market’s returns with remarkable accuracy — as long as you do the exact opposite of the managers. In 1951, for example, cash balances in stock funds set their all-time record high of 15%; over the next decade, stocks grew at 16.4% annually, among the biggest gains the U.S. market has ever produced. And when did cash positions hit their record low? In 1972, when they shrank to just 4.2%; that’s the most optimistic fund managers have ever been. Over the next two years, U.S. stocks lost 37% of their value, the worst loss since the Great Depression.
So what are cash levels telling us now? At the end of 1998, they stood at 4.8%, the lowest level since 1972. The lesson: Unless fund managers have suddenly become far better forecasters, this is an excellent time to be a cautious investor.
All the lessons of fund history, then, boil down to fairly basic rules. Chasing hot returns leads to nothing but heartbreak. And the most powerful tools for successful fund investing are the simplest: prudence and patience.
Over the full sweep of time, mutual funds have shown that they are probably the greatest contribution to financial democracy ever devised.
But like every democratic structure, they are far from perfect.
Failing to beat the market, as 90% of all funds have done for the past four years running, is a longstanding pattern (see the chart).
When regulators leave the least loophole, fund companies will pile through it — and investors will end up sorry (see the events of 1954, 1967, 1986).
And if a fund idea is trendy, it’s probably bad for you (see 1929, 1968, 1983, 1991).
John C. Bogle, “Has Your Fund Manager Betrayed Your Trust?
Consider the ‘Stewardship Quotient'”
Definitions of FIDUCIARY DUTY, MUTUAL FUND, and PAST in The Devil’s Financial Dictionary
William A. Birdthistle, Empire of the Fund: The Way We Save Now
Matthew P. Fink, The Rise of Mutual Funds: An Insider’s View
Source: Money Magazine, April 1999