Wednesday, October 12, 2011


The Financial Times article, “Fund mergers obscure performance” highlights a real problem in the investment industry. Many mutual fund companies close poor performing funds or merge them into better performing funds.  This may not sound like a huge problem, but it enables fund companies to appear more successful than they really are. 

A quick search shows that one large fund family has 204 mutual funds.  Even if only 5% of these funds outperform their relevant benchmark index, they would still have over 10 funds they could tout in investment magazines.  The strategy of having many, many, many funds, allows large fund families to always have plenty of funds with good track records.  When you open Money magazine, or SmartMoney, or Kiplinger’s you will see dozens of ads for mutual funds with fantastic track records.  The problem is the outperforming funds were probably only lucky and quite likely won’t be as lucky in the future.

As I pointed out in previous posts, the majority of mutual funds underperform index funds.  A quick search on Morningstar’s mutual fund database shows only 25% of large cap blend mutual funds that have a 10-year return higher than their benchmark index and only 13% of mid cap blend funds beat their benchmarks.  However, your odds for picking one of those outperforming funds 10 years ago was much smaller than 25% for large cap funds and much smaller than 13% for mid cap funds.  Why?

Many, many funds that were around 10 years ago have disappeared by now.  Hundreds of funds are closed each year and hundreds more are opened.  This is how the mutual fund industry dupes folks into believing they can beat passive index funds.  Just think about it, if you personally could run 10 different stock portfolios, you could probably produce 4 or 5 that would beat passive index funds even if you just randomly picked your stocks.  After a few years, you would just close the funds with poor performance and open new funds with no track record.  Again, after a few years close the funds with poor performance and start new funds.  Do this over and over until you have a dozen funds with great track records.  This is exactly what many fund families do!

So, instead of having a 25% chance of picking a Large Cap fund that will outperform an index fund, your odds are probably more like 10% or even less.  In the Mid Cap space your odds are likely less than 5% of picking a fund that will outperform a good low cost Mid Cap index fund.  And, if you own any of these funds in a taxable account, your odds of outperforming simple index funds on an after-tax basis is very close to ZERO due to the increased capital gains active funds pass on to their investors who have to pay taxes on those gains.  

Rick Ferri has written a great article on this topic titled: Fund Investors Should Lead "Occupy Boston". Every mutual fund investor should read it.


But wait, it actually is worse than that!  First, I need to give you a little primer on equity mutual fund “style boxes.”

Mutual fund databases like Morningstar and Lipper segregate domestic stock mutual funds into 9 categories based on the type of stocks the funds focus on.  Funds are segregated by the size of the firms whose stocks they buy: Large Capitalization companies (referred to as Large Caps), Mid Caps, and Small Caps.  Then, each of these three tiers are further segregated into funds that focus on high growth companies (Growth Funds) or on stocks that are “cheap” referred to as Value Funds.  The third category is for funds that buy both “Growth” stocks and “Value” stocks.  This category is usually called “Core” or “Blend.”  So, we end up with 9 investment “style” boxes.


Value fund managers want to be measured against Value indexes and Growth fund managers want to be measured against Growth indexes.  We’ve seen 25-year periods where Value and Growth was a dead heat tie.  (This is why I don’t recommend messing with Value or Growth and just buy Core or Blend funds, preferably index funds).  But, sometimes Value stocks perform better than Growth stocks over shorter periods of time like 5 years. Sometimes Growth beats Value.  One really never knows when or why one will outperform the other.  But, it is important for investors to know which index should be used to measure their funds performance.


The 5 years leading up to 2006 was a period where Large Value stocks had dramatically outperformed Large Growth stocks.  One particular fund family had two Large Cap funds – one was a Large Cap Value Fund (ticker: BBTGX) and the other a Large Cap Growth Fund (ticker: BLGAX) as follows:

                                                            Value               Core                Growth
5-year Large Cap Index Returns        5.3%               0.5%                -3.6%
BB&T Large Cap Funds                     4.0                                          -4.9
Underperformance                -1.3%                                       -1.3%

Both the Large Cap Value Fund and the Large Cap Growth Fund had performed poorly during the 5-year period. Each fund had failed to beat their passive index by approximately -1.3% per year for 5 years.

If a fund family had no morals, they might think to merge the two funds, bury the track record of the worst of the two bad funds, keep the “least bad” track record, and move the “new” fund to a category where the poor track record “appears” to be better.  So, BB&T did just that!

Despite the change in the name and the focus, the fund actually kept its performance track record!  Really, I’m not kidding!  The 4.0% 5-year return looked bad in the Large Cap Value category where the benchmark index was 5.3%, but suddenly looked great in the Large Cap Core category where the benchmark index return was just 0.5%!

But they didn’t stop there.  Once BB&T had successfully “moved” the Large Cap Value performance track record into the Large Cap Core category, on January 29, 2007 BB&T merged the lousy Large Cap Growth Fund into the new fund named Large Cap Fund

This is how the owners of the Large Cap Growth Fund came to own a Large Cap Core Fund with a Large Cap Value track record!  Seriously, I’m not making this up!  This should be illegal, but if it is, they got away with it. 

Just to obscure the issue as much as possible, in 2010 BB&T renamed “The BB&T Large Cap Fund” to “The Select Equity Fund.”  Lastly, just in case someone was still able to connect the dots, recently they changed the name yet again to the “Sterling Capital Select Equity Fund” but kept the original ticker symbol of BBTGX

However, with all this changing of the name, and the focus of the fund, and jumping of style boxes, what was not changed is the poor performance.  Five years later, the Sterling Capital Select Equity Fund now ranks in the bottom 5% of all Large Cap Blend Funds in the Morningstar mutual fund database.  With a 5-year annualized return (loss) of -6.4%, the Sterling Capital Select Equity Fund once again trails its benchmark – underperforming the S&P 500 Index by a whopping -5.2%.

In my opinion it should be illegal for a mutual fund to officially change its investment strategy and performance benchmark and keep its old performance track record.  I believe, in a situation like this, the old fund with the old strategy should be deemed to have been closed and a new fund with NO PERFORMANCE track record has been created.  

In short, STYLE BOX JUMPING SHOULD BE OUTLAWED.  Mutual funds without morals need to be eradicated from the investment industry.  The investment managers and the mutual fund boards of directors that allow this to happen should be banned from the industry.

The lesson here: Actively managed mutual fund performance is even worse than you think. So, just buy low cost index funds.

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