Investors Need to Raise Bar for Fund Managers

The positive spin on Wall Street this year is that it’s a “stock picker’s market.”

In other words, if your money is invested with someone who knows how to pick stocks well, your portfolio’s performance should be better than average--because plenty of opportunities are springing up even when the market overall struggles.

Put aside, for a moment, the obvious question of why you’d ever want your portfolio in the hands of someone who doesn’t pick stocks well, unless you’ve chosen to own an index portfolio that merely mimics the performance of a broad swath of stocks.

In a “stock picker’s market,” money managers are supposed to be able to demonstrate their investing prowess. But Wall Street has a generous view of what constitutes investing prowess: Fund managers can take credit for beating their relevant index even if they’ve still lost significant money on your behalf.

In the first half of this year, about 59% of U.S. stock mutual funds beat the blue-chip Standard & Poor’s 500 index, which sank 6.7% (including dividends), according to fund tracker Morningstar Inc.

In their mid-year reports to shareholders, blue-chip funds that beat the S&P; index will undoubtedly make that point--even if they also finished the period in the red, just not more than 6.7% in the red.

During the last half of the 1990s, when the S&P; index trounced actively managed stock funds year after year, portfolio managers had all sorts of good reasons for not keeping up. They said the S&P; was too heavy in tech, it was overvalued, it was benefiting from a herd-instinct flight to quality by global investors, etc.

In that roaring bull market, the rising tide did manage to lift all (or at least most) boats. So fund owners were supposed to be happy that they were making money, period--even if they weren’t making as much as they could have just indexing their portfolios to the S&P; 500.

Now, in a stock picker’s market--the kind of environment many portfolio managers have been eagerly awaiting since the early 1990s--the true test of talent ought to be whether a manager can produce positive returns even if the S&P; and other broad indexes decline, or are flat.

But chances are your fund manager won’t see it that way. You’ll be asked to feel satisfied even if you’re losing money, as long as the loss isn’t as bad as the S&P;’s decline.

You can, of course, vote with your feet, or rather with your telephone or computer mouse: It’s easy enough to leave funds that don’t live up to your expectations and invest in better funds.

Many investors know too well, however, that inertia is a strong force. People tend to stay too long in lousy mutual funds (and individual stocks), always hoping that performance will improve.

The capital-gains argument also is a popular excuse--as in, “I don’t want to sell because I’ve got long-term gains in the fund and I don’t want to pay the tax bill.”

But that really isn’t the good excuse many people assume. Remember: If you own a fund in a fully taxable account (i.e., not a tax-sheltered account), you’re paying taxes on realized capital gains each year.

Unless the fund has been very tax efficient, which typically means it has held many stocks for long periods, the built-in taxable gain you would incur in selling may be much smaller than you imagine.

Naturally, the decision of whether to sell a fund ought to hinge on more than six months’ worth of performance. But for investors whose stock funds have been disappointing them for years, the first six months provided a good stretch by which to judge what a manager might be capable of in this new market environment.

Seventy-five percent of New York Stock Exchange issues performed better than the S&P; 500 index in the first half, according to strategist Tobias Levkovich at brokerage Salomon Smith Barney. Some of the stocks in that universe merely fell less than the S&P;, but many more posted gains while the index fell--toymaker Mattel, for example, which is up 26% this year; aluminum giant Alcoa, which is up 19%; and retailer Abercrombie & Fitch, up 104%.

So there was no shortage of ideas that worked in the first half, regardless of a manager’s style of investing. If a fund lost money in this environment, shareholders deserve a detailed explanation of what went wrong and why they should keep faith.

Could this “stock picker’s market” really persist for years? It’s a reasonable bet, if you consider that the most reasonable outlook for the economy may not be boom, or bust (despite what the bears argue), but something in between.

The U.S. economy is so large that, even with modest growth, there will always be some companies that perform well. The job of a fund manager is to find those opportunities--not to be stuck with investments that aren’t working and have few prospects for significant improvement in the near term.

It may have been fine for fund shareholders to be content with mediocre managers in the spectacular bull market of the late ‘90s, when even mediocre returns (relative to fund averages or key indexes) were impressive.

Now, if market gains will be harder to come by, investors will have to be much harsher judges of fund performance or the lack thereof.

It is, after all, your money. You’re paying to have it managed well, even if those fund management fees aren’t easily visible (until you take a closer look).

As with anything else you buy, you should get what you pay for.

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Tom Petruno can be reached at tom.petruno@latimes.com. For recent columns on the Web, go to https://www.latimes.com/petruno.

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Active Beats Passive--Again

In the first half of this year, the majority of actively managed domestic stock mutual funds performed better than the blue-chip Standard & Poor’s 500 index, which fell 6.7%. Actively managed funds also beat the index in 2000--for the first time since 1993. Even so, a fund that beats the index still might be in the red, analysts note.

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Percentage of actively managed domestic stock funds that beat the S&P; 500 each year:

First half of 2001: 58.8%

Source: Morningstar Inc.