Avoid the Pitfalls of Portfolio Inertia

By Tom Petruno

July 10, 2005 12 AM PT

Times Staff Writer

If the stock market were truly efficient, Ron Muhlenkamp would be managing a lot more money, and many of his peers would be managing a lot less.

The eponymous Muhlenkamp Fund, which holds $2.7 billion in clients’ assets, has generated returns averaging 16.9% a year over the last 10 years and 13.1% a year over the last five.

Now compare that with Fidelity Magellan. With $55 billion in assets, it’s one of the world’s best-known stock funds. Its 10-year average annualized return: 7.6%, less than half Muhlenkamp’s results.

And over the last five years, Magellan has lost 4.2% a year.

There may be some good reasons why so many people have kept their money in Magellan all these years. But it would be pretty naive to think that inertia hasn’t been a big factor.

And much of that inertia may be on the part of investors who own Magellan in 401(k) and similar employer retirement plans.

“Set it and forget it” has been the investment strategy of millions in retirement savings programs over the last 20 years. The performance results of Magellan and some other mega-funds, however, ought to serve as a potent reminder of the dangers of simply staying on auto-pilot -- particularly in a stock market that could spend many more years struggling to make progress.

It has been a standard joke in the investment business that people will spend far more time researching which car, TV set or weed whacker to buy than which mutual funds to entrust with their life savings.

That was funny in the 1990s, when it didn’t matter much which fund you owned. Nearly everything was going up.

But 5 1/2 years into this decade, some investors have suffered mightily for failing to pay attention to their funds’ performance, or for being unwilling to shift their portfolios, even modestly, to better cope with a changing market landscape.

You know who you are. And you know you can do better. It’s never too late.

Many people have had a rigid buy-and-hold faith in the blue-chip Standard & Poor’s 500 index. The general merits of indexing for the very long term are undeniable: low cost, broad diversification and tax efficiency.

But it’s a painful fact that a buy-and-hold investor in the S&P; 500 still hasn’t made a dime in this decade on the money he had in the index on Dec. 31, 1999. Even including dividends earned, that investor has lost 2.2% a year on his savings, measured through the first half of this year.

By contrast, U.S. indexes of small and mid-size stocks hit record highs on Friday, continuing a winning streak over big-name stocks that began in 2000. The S&P; 600, an index of small-company stocks, has risen 10.9% a year since the end of 1999.

As smaller stocks have won the investment derby over the last five years, fund managers who have had the flexibility to invest in any market sector have had an inherent advantage over peers who, by charter or preference, have remained focused on big-name stocks.

Ron Muhlenkamp, who manages his fund from the Pittsburgh suburb of Wexford, owns shares of global financial services giant Citigroup Inc. He also owns a stake in Fidelity National Financial Inc., a mid-size company that is a leader in real estate title insurance.

Muhlenkamp says that he doesn’t care at all whether a broad market sector is hot or not. The only relevant question, he says, is: “What companies do you like?”

Lately, Muhlenkamp says, some very large stocks have shown up on his buy list, as he hunts for “good companies at cheap prices.” He has put some money to work in drug and medical products maker Johnson & Johnson, for instance.

Given rising competitive pressures in the drug business, “We know that the future isn’t going to be as good as the past” for companies like J&J;, Muhlenkamp said. “But I still think the future is going to be better than the stock price suggests.”

If he’s right, it could help Fidelity Magellan’s future performance too; Johnson & Johnson is a major holding in Magellan.

Indeed, asked about Magellan’s track record, a Fidelity spokesman in Boston said the fund was banking on a comeback in the large-capitalization growth stocks that dominate the portfolio, and which have been heavily out of favor for the last five years.

Manager Robert Stansky believes that “at some point soon it’s likely that the market may rotate and favor large-cap stocks again,” the Fidelity spokesman said. “That’s why Bob is confident in the fund’s recent positioning.”

The future may well be kinder to Magellan. But the problem for the fund’s investors is that Stansky has a lot of ground to make up.

So here’s a suggestion for any investor who has a large amount of savings in Magellan or any other stock mutual fund: Break loose of inertia. Focus on doing a better job of diversifying your assets.

You may realize that you should have improved your diversification five years ago. You may fear that changing the mix now may result in overpaying for some stock sectors -- particularly smaller issues that have had a great run, or foreign stocks that also have performed better than U.S. shares in recent years.

But what if the market’s trends since 2000 stay in place for two more years, or five more, or 10 more?

You can’t know, so all you can do is spread your money around in the hope of always having something that’s performing well. This is the most basic rule of investing, yet it’s often ignored.

It’s a natural temptation to want one stock fund to do it all for you. That’s the “core” fund concept: You build a portfolio around one well-diversified fund. That’s how Magellan rose to fame. It became a core fund for tens of thousands of investors in the 1980s and early 1990s.

Likewise, many investors today trust S&P; 500 index funds as their only core holding.

Indexing may triumph in the very long run. But it’s interesting to look at the performance of the largest U.S. stock funds over the last 15 years, a long enough stretch of time for most people.

Most of the biggest funds got that way because they beat the S&P;, even though these funds tend to own many of the same blue-chip shares that are in the index.

The Vanguard 500 Index fund, which tracks the S&P; 500, was up 350% over the 15-year period ended June 30, according to fund tracker Lipper Inc.

By contrast, Fidelity Contrafund soared 678%; Dodge & Cox Stock fund gained 642%; Investment Co. of America, managed by the American Funds group, rose 402%.

Any or all of them might continue to be a good core fund for an investment portfolio. But because you can’t know what the next 15 years will bring, the more prudent move might be to use two or three as core funds, rather than putting all of your chips on one. (The disparity of the funds’ returns over the last 15 years, after all, isn’t peanuts. And many Wall Street pros believe it will only get tougher to pick stocks, not easier. Why trust just one manager?)

Beyond the blue-chip fund universe, it’s important for investors to always have some money in each of the other major market sectors -- including small and mid-size stocks, foreign issues and bonds. Following this simple guideline would have saved many people a lot of grief if only they had taken it to heart five years ago.

The problem investors often face in improving their diversification is that they invest primarily through their 401(k) plans, and the choices in those plans can be limited.

Still, your 401(k) options probably are more numerous than they were a decade ago. If you -- or your financial advisor -- haven’t at least looked lately at the choices in your plan, this is a good time to do so.

You may find that, to create a truly diversified portfolio and to find successful but still relatively little-known stock pickers like Ron Muhlenkamp, you’ll have to look outside your 401(k).

That will take work. Because many people don’t want to do that kind of work, Muhlenkamp manages a lot less money than his track record suggests he ought to have.

Here’s a modest proposal: By paying more attention to your portfolio, and looking for ways to improve your mix of fund managers, you stand a better chance of finishing the next five years with a bigger nest egg -- instead of just more regrets.

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15 years with the giants

There has been a wide disparity in the performance of the nationOs most popular stock mutual funds over the last 15 years. Here are total returns, meaning price appreciation plus any dividend or interest income, through June 30 for some of the largest funds by assets:

Fidelity Low-Priced Stock: 1,046%

Fidelity Contrafund: 678%

Dodge & Cox Stock: 642%

Growth Fund of America*: 517%

Vanguard Windsor II: 458%

Washington Mutual Investors*: 431%

Investment Co. of America*: 402%

Vanguard Wellington: 377%

Vanguard 500 Index: 350%

Fidelity Magellan: 340%

*Managed by American Funds Group.

Source: Lipper Inc.