Some mutual funds have distinguished themselves with unconventional strategies. Hussman Strategic Growth (HSGFX) takes both long and short positions. Gateway Fund (GATEX) has achieved an outstanding balance between risk and reward by selling index options against its stock selection. Mairs and Powers Growth invest in companies of all sizes but emphasize small companies based in the Midwest.
I suspect that numerous talented fund managers have original ideas but do not want to take the risk of implementing them. There is safety in numbers. If a fund comes close to its benchmark, the manager’s performance is hard to criticize, and he might feel his job is more secure. On the other hand, if a manager sticks his neck out by deviating from a benchmark and the gamble does not pay off, his job might be on the line.
This happened to Jeffrey Vinik, the former manager of Fidelity Magellan (then the largest mutual fund), who in 1995–1996 believed the stock market to be overvalued. As a result, he placed a significant portion of the fund’s assets in bonds. When the market correction that Vinik feared did not materialize, Fidelity Magellan underperformed the S&P 500 by a margin of more than 10 percent in 1996—the only time in the past 30 years that the fund lagged by such a large amount. As a result, Vinik lost his job at Fidelity in 1996. Since then, Fidelity Magellan has performed much like the S&P 500, for better or worse.
Another type of manager who has consistently beaten the market is a small-cap stock picker, particularly a small company growth fund manager. That’s because the vast majority of publicly traded stocks are small-caps (companies for which the total value of outstanding shares is below $2 billion). Recall that the large-cap S&P 500 Index has only 500 out of the more than 5,000 NYSE and NASDAQ stocks, and the behavior of the largest 50 of the 500 dominate the index. Approximately 10 percent of traded stocks constitute midcaps, and 80 percent—more than 3,500 issues—make up the universe of small-caps.
With so many different stocks, of which each represents a relatively small investment opportunity, a fund manager has a good chance of unearthing an undiscovered gem and accumulating a significant position in the small company before the competition catches on. In contrast, large company stocks are followed by a number of analysts. Particularly in the age of fair and full disclosure, any insight that an analyst might have about a large company quickly becomes disseminated throughout the market.
The historical success of small-cap managers has been relative to the Russell 2000 Index and the Russell 2000 Growth Index. The Russell 2000 Indexes, the first small-cap benchmarks, represent a fairly complete representation of the small-cap market.
In terms of investment returns from small-cap indexes, the S&P 600 Index has performed more strongly than the Russell 2000 Index. Indeed, the S&P 600 Index, the S&P 600 Growth Index, and the S&P 600 Value Index have all outperformed a majority of mutual funds with similar objectives during the past ten years. With only 600 stocks, the S&P 600 Index is far from a complete representation of the small-cap universe. Its composition reflects the insights of the Standard and Poor’s investment committee in deciding which small fraction of stocks to select from among the many available. Apparently those insights, even though made public, have added significant value. Even though past results do not predict future performance, it appears that investors could avail themselves of a potentially superior small-cap investment by holding the ETFs that correspond to the S&P 600 Indexes.
Insofar as large-cap growth managers have been relatively successful in beating the benchmark Russell 1000 Index during the past ten years, you might be better off holding a top-performing fund than holding a large-cap growth ETF. Large-cap growth mutual funds selected from large-cap growth funds in operation for at least ten years. All the funds listed have been in the top 25 percent of large-cap growth funds in risk-adjusted performance for the one-, three-, five-, and ten-year periods ended 12/31/2005. Even though it’s not guaranteed that these funds will continue their winning streaks, their track record is impressive.
Read More : How a Few Mutual Fund Managers Have Beaten the Indexes
