Stocks versus Funds

Stocks versus Funds

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utual funds vs. individual stocks: a classic (and annual) comparison. As shown in Figure 1, Morningstar reported on 5,758 U.S.-based companies (i.e. stocks) which were in existence for the entire year of 2003. The mean one-year return was an astonishing 86.9%. The median one year return (recall that median is unaffected by a small number of extremely high returns) was an impressive 42.4%. The share-weighted one year return was 57.8%. This share-weighted figure is not generated by Morningstar. The share-weighted return (as calculated by the author) assigns a proportionally greater weight to stocks that have more shares outstanding and less weight to thinly held stocks. These three performance figures collectively suggest that the equity market in 2003, as measured by individual securities, was unusually buoyant and widespread. Indeed, 85% of the 5,758 stocks had a positive return for calendar year 2003. The average return for those 4,892 stocks was just over 108%! The median positive return for was a saner 51.8%.

Figure 1. Individual U.S. Stocks

On the other hand, there were 866 stocks (15% of the 5,758) that had a negative return in 2003. Even in a widely bullish market there is always a certain segment of stocks that do not share in the updraft. In fact, of the 866 stocks which had a negative one year return the average performance was a sobering -33.4%. The median negative return was -22.2%.

Over the 3 year period ending 12/31/03 the mean return for the 5,500 individual stocks which survived the entire 36 months was 9.0%. A higher 3 year median return of 9.9% indicates that the distribution of 3 year stock returns is slightly skewed to the left. In other words, there were a large number of stocks with negative 3 year returns (2,046 stocks, or 37.2% of the 5,500) and a relatively small number of stocks with abnormally high returns. Such outliers on the positive side have a tendency to lift the mean over the median. Only 109 stocks had a 3 year return over 100% compared to 1,309 stocks with a return in excess of 100% during 2003.

The median return for stocks is also higher than the mean return over the 5 and 10 year periods ending 12/31/03. Over the 5 year period we observe that 39% of the 4,823 stocks had a negative 5 year annualized return which averaged -22.1%. The average 3 year performance for the 61% of stocks with a positive return was 17.8%. The net result of the imbalance is an overall mean return (2.2%) which is lower than the median return of 5.4%. Over the 10 year period the same relationship between mean and median return persisted. Stunningly, just over 27% of the 2,829 stocks which had a 10 year performance history had a negative 10 year annualized return. That 764 stocks generated a negative ten year annualized return from 1994-2003 - during one of the greatest bull markets in U.S. history - is truly north of amazing. Every equity index in the Morningstar database which had performance data back to 1994 (there were 30 of them) reported a positive 10 year average annual return as of year-end 2003. Such a phenomenon exposes a strange side of "survivor bias", that being the degradation of aggregate equity returns by survivors!

On the other side of the aisle, 2,584 equity mutual funds had at least one year's worth of performance by the end of 2003. The selection criteria for mutual funds eliminated those with less than 12 months of performance and those with more than 15% of their portfolios in cash, bonds, or non-U.S. stock. Redundant funds were also omitted (i.e. only "Distinct Portfolios" were selected) from the Morningstar Principia data. The mean one year return for funds was 34.0% and the median return was 31.1% -- both extremely high numbers. The net-asset weighted return was 31.4% suggesting that the one-year performance among large funds was mirrored by smaller funds.

Figure 2. U.S. Equity Mutual Funds

Only 8 funds (0.3% of the group) had a negative one year return. The average one year return for those 8 lost souls was a negative 10%. Two of the 8 funds deserve some special attention (see Dante's Inferno All-Stars below). Another little fun fact about Ameritor Investment is an expense ratio of over 21%. But that's child's play compared to the expense ratio of 42.4% which Frontier Equity is sporting.

Dante's Inferno All-Stars

Equity Fund	2003 Return (%)	Expense Ratio (%)
Ameritor Investment	-10.53	21.6
Frontier Equity	-44.23	42.4

Over the past three and five years (as of 12/31/03) the performance of U.S. equity mutual funds has been dismal. Nearly two-thirds had a negative 3 year annualized return and the mean return of all 2,269 funds which had a 3 year performance history was -2.2%. The median return over three years was even worse at negative 3.3%.

An anomaly is exposed in the 3 year time period: 64.2% of all equity funds had a negative three year average return whereas only 37.2% of the 5,500 individual stocks generated a negative 3 year return. This is a potent reminder of the redundancy which exists in the mutual fund marketplace. Too many funds investing in the same clutch of stocks! When many of the popular growth stocks began capsizing in 2000 and 2001 the meltdown in the vast majority of growth mutual funds was virtually assured -- precisely because of a tremendous amount of stock overlap in the growth fund sector.

Over five years the average U.S. equity fund produced an annualized return of 3.5%, which equaled the return of T-bills over the same time frame. (Whether that fact is good news or bad news is a matter of perspective). Nevertheless, nearly 36% of all equity funds had a negative annualized return over the past 5 years. Another reminder of how 200 (or less) poorly performing, though widely held stocks, can wreak havoc on a large number of equity funds.

Over 10 years, the picture of mutual fund performance returns to a more normal state. The mean return for 867 U.S. equity funds in existence for at least the full ten years was 9.6% (median return was 9.7%) and less than one percent had a negative annualized return. The highest 10 year annualized return was a stunning 20.6% by Calamos Growth A, followed closely by Vanguard Health Care at 20.2%. Equally stunning is the pathetic 10 year performance of Frontier Equity which somehow managed to generate a 10 year annualized return of -27.6%. American Heritage was a close second with a -23.5% average annual return between 1994-2003. Two funds truly in a class by themselves! Another weird case of survivor bias!

On to a related topic: the use of benchmark returns to make sense of the equity world. Figure 3 includes three common benchmarks which are utilized to gauge the U.S. equity market. As can be seen, at year-end 2001 the S&P 500 had a -11.9% one-year return, following by a 22.1% loss in 2002, and then a stunning 28.7% one-year gain in 2003. Both the midcap and small cap indices showed similar volatility in annual returns over the past 3 years. Here's the risk: using annual performance data to manage long-term portfolios (as far too many 401(k) participants do) can lead to reactionary, non-strategic management with the ironic result of the investor "churning" themselves.

Figure 3. The Rolling Terrain of Return

A helpful analytical technique to minimize this type of reactionary micro-management is to make use of rolling returns in an attempt to smooth potentially volatile annual performance data. Having said that, notice that the 3 and 5 year rolling returns for each index in Figure 3 are still very susceptible to large gyrations from year to year. For instance, the S&P 500 had a 3 year rolling return of -1.0% as of 12/31/01, -14.6% by 12/31/02, and -4.1% at year-end 2003.

Only when using 10 year rolling averages do we see a marked reduction in return volatility from period to period. Of course the annual volatility is still "in" the data, we just don't observe it when using a sufficiently long rolling return time frame. This is a very instructive example. The volatility of equity investments can be significant even over 3 and 5 year rolling time frames, but more importantly, there is a central tendency of equity returns that manifests itself over a sufficiently long enough time frame.

Equity investors absolutely must understand that downside risks are very real inside of 5 years, or even 7 years. Generally over 10 years or longer the excesses on both the upside and downside are absorbed into the mean and the returns that long-term investments are based upon are more clearly observed. Keeping clients on-board during rough periods is a function of educating them that such periods will occur. Show clients the good -- and the rough -- 5 year rolling returns. Let clients see that volatility and losses happen (as if they don't already know!). But by also showing rolling performance over periods of sufficient length (e.g. 10 years) it becomes evident that the central tendency of equity returns is what must be focused on.

Teach clients the reality of volatility over shorter time frames while centering attention on long-term central tendency of equity returns. If not put into a long-term context, volatility of return - even over 3 and 5 year rolling periods - can easily be used by clients as a rationale for gutting their portfolio. If investors will not make long-term commitments they will repeatedly experience rolling periods of self-inflicted mediocrity. Educating clients about risk (i.e. return volatility) is the antidote to the sensational news of the day that causes them to abandon ship when only a slight course correction may have been needed.

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Craig L. Israelsen is an Associate Professor in the Department of Consumer and Family Economics at the University of Missouri-Columbia (http://www.missouri.edu/index.cfm) where he teaches courses in Personal Finance and Family Living. He holds a Ph.D. in Family Resource Management from Brigham Young University. He received a B.S. in Agribusiness and a M.S. in Agricultural Economics from Utah State University. Primary among his research interests is the analysis of mutual funds. He writes monthly for Financial Planning magazine.