Mutual Fund Mea Culpa

I firmly believe that revisiting your mistakes is one of the best ways to learn. Two of the most important lessons I learned early on in my investing experience were: 1) high fees negatively impact returns and 2) actively managed funds typically under-perform passive indexes over longer periods of time. [1] Prior to using low cost index funds in an asset allocation strategy I owned a number of high fee actively managed mutual funds. Below I’ve compiled a list of the active funds that I used to own against a comparable offering from Vanguard. Ten year annualized returns and volatility of the funds are included for comparison. A more detailed description of my ownership with my insights is included for each fund below.

Fund ER 10 yr
Annualized
Return
Volatility
(Std Dev)
US Stocks
Franklin Founding Funds Allocator Fund 0.99% 5.6% 18.9%
CGM Focus Fund 2.26% 7.4% 34.5%
Hennessy/Akre Focus Fund* 1.46%/1.34% 10.3% 19.9%
Vanguard Total Market 0.17% 8.0% 19.3%
Emerging Markets
Matthews China Fund 1.13% 11.3% 41.1%
Vanguard Emerging Markets 0.33% 8.0% 35.2%

Franklin Founding Funds Allocation Fund (FFALX)
Full disclosure: I didn’t choose this fund. My Roth IRA contributions were invested in this fund by default. I ended up holding FFALX for about 18 months before I started paying attention to fee structures. The front load is nothing sort of egregious and a serious red flag. A quick inquiry on Morningstar reveals that FFALX is a fund of funds, holding 3 other Franklin Templeton funds: Franklin Income (FNCFX), Franklin Mutual Shares (FMSHX) and Templeton Growth (FTGFX). All of these funds feature higher turnover ratios than the parent fund, so that 4% turnover is a little deceptive. Morningstar also ranks all of these constituent funds as large cap value with each having a mix of domestic and international stock exposure. FNCFX actually has about a 30% holding in bonds. A majority of which are below investment grade (read junk bonds) according to Franklin Templeton’s page. It’s worth noting that the total market index beat FFALX by a full 2.5% over the previous 10 years while experiencing similar volatility. Regarding fixed income, junk bonds may have higher yields but tend to produce losses during bad economic times (precisely when you need a safe asset to limit losses or provide stable income). There are far better options available, like a total bond fund, Treasuries fund, or better yet direct Treasuries…skip the junk.

Front Load 5.75%
Back Load
Management
12b-1 0.25%
Other 0.16%
Acquired Fund Fees 0.58%
Expense Ratio 0.99%
Turnover 4%

CGM Focus Fund (CGMFX)
This fund I chose based on a recommendation from the back of a certain pundit’s book (not something I recommend). If the expense ratio isn’t enough to drive you away consider how it’s managed. Ken Heebner manages this fund and from the turnover you can see that he’s more of a trader than a long-term investor. Heebner has also been known to short stocks from time to time. From the prospectus

If market conditions so warrant, the Fund may establish short positions in specific securities or stock indices.

Combine the short selling with the high turnover and you have a fund with an insane amount of volatility–roughly on par with the Vanguard Emerging Markets fund. The better option here is a simple domestic stock index, maybe a small cap index if you can deal with the volatility and want the potential for a slightly higher return.

Front Load
Back Load
Management 0.95%
12b-1
Other 1.31%
Expense Ratio 2.26%
Turnover 266%

Hennessy Focus Fund (HFCSX)/Akre Focus Fund (AKREX)*
I chose the Hennessy Focus Fund (formerly the FBR Focus Fund) based on the reputation of manager Chuck Akre. Akre actually left in 2009 and opened his own shop. I followed suit and held the Akre Focus Fund for an additional 2 years before leaving in late 2011. Of all the funds here AKREX is the one I still occasionally keep an eye on for the simple fact that he’s done really well. After fees Akre generated a ten year annualized return that was 2.3% better than the total market index with a similar level of volatility (some of this may be due to factor exposure). His turnover is also much more respectable compared to other managers on this list. The problem with Akre is one of mortality. While I wish him the best, he’s getting up there in age and will most likely pass his duties off to someone else. Ultimately I was faced with the problem of trying to find a new fund manager. Based on reports compiled by SPIVA the odds of finding a good one with a record as consistent as Akre’s aren’t tremendously high. In my opinion the risk of picking a bad manager outweighs the benefit of picking a good one.

HFCSX AKREX
Front Load
Back Load
Management 0.90% 0.90%
12b-1 0.15% 0.25%
Other 0.41% 0.19%
Expense Ratio 1.46% 1.34%
Turnover 18% 16%

Matthews China Fund (MCHFX)
China’s economy is booming, what a great place to invest! Right? At least that’s what I used to think back in the 2008-2009 time frame (there’s some recency bias here on my part). The Matthews fund provided outstanding returns of 64.8% and 70.1% in 2006 and 2007 respectively–destroying the Vanguard Emerging Markets Index in the process (29.4% and 38.9% in 2006 and 2007). However, comparing a China fund to a broad emerging markets index isn’t a fair comparison as the Vanguard fund wasn’t a pure play on Chinese stock. The fund had exposure to China of roughly 11.1% In 2006 and 15.1% and 2007. But I think that’s the big insight here. Fees aside I had way too much exposure to a single developing country. This inherently brings with it a lot of volatility as the numbers above confirm. A better choice would have been the diversified emerging markets fund as a means to limit my exposure to any single economy.

Front Load
Back Load
Management 0.66%
12b-1
Other 0.47%
Expense Ratio 1.13%
Turnover 10%

In closing there are some really horrible options out there in mutual fund land. The lesson here is that you really need to take the time to understand what you own. Perhaps that’s the benefit of index funds: I may not know how a given index will perform in the future but I know the matching index fund will track said index. Fortunately for me the actively managed funds I held were mostly my choice and I had the ability to change. Some diligence is still required for strategies built around indexing. Here’s a write up from Michael Johnston on an S&P 500 index fund with an absurd expense ratio of 0.60%:
The Worst Mutual Fund in the World by Michael Johnston

References
1. Ferri, Richard A. and Alex C. Benke. A Case for Index Fund Portfolios. http://www.rickferri.com/WhitePaper.pdf

Notes
*Returns from the Hennessy Focus Fund and Akre Focus Fund were combined in 2009 to follow the tenure of Chuck Akre. Thus the returns and volatility reported represent the management of Akre.


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