On January 9th 2016, Barron’s published a story titled, The Market Beaters. They had asked Morningstar to find U.S. stock funds with a long-term record of beating the S&P 500 index. They also wanted to ensure that the same manager was still running the fund.
Morningstar obliged. They gave Barron’s a list of nine funds. Each had a better 1, 3, 5, 10 and 25 year return than the S&P 500.
But Burton Malkiel, author of A Random Walk Down Wall Streetsays we shouldn’t jump into funds that having winning past records. “There is no way to choose the best managers in advance,” he says. “I have calculated the results…with the best recent year performance, best recent two-year performance, best five-year and ten-year performance and not one of these strategies produced above average [future] returns.”
Burton Malkiel’s words might be haunting Barron’s. As they explained in their story, just three months after receiving their list of nine winning funds from Morningstar, five of the funds fell from grace. Barron’s may have questioned whether to continue with their story. But they decided to work with the unbroken pieces. They wrote about four winning mutual fund managers (instead of the original nine) in their January 9th, 2016 story.
Fastforward twelve months. Readers who bought those funds, after the story was published, may feel duped. The funds averaged just 0.80 percent for 2016. Vanguard’s S&P 500 index gained 11.93 percent. Vanguard’s Total Stock Market index gained 12.66 percent. As a group, Barron’s cherry-picked funds are no longer long-term winners.
The indexes now have a better record over the past 1 year, 3 year and 15 year periods. So when publications recommend “the best actively managed funds to buy,” you should just smile.
In 2010, Business Insider’s Nick Levis wrote, “7 Mutual Funds To Buy.” They had all beaten the S&P 500. Five years later, I looked at their performance. Since that story’s publication, all seven of them had lost to the S&P 500.
The same year, U.S. News and World Report published, “The 100 Best Mutual Funds For The Long Term.” They had selected 50 stock market funds. Each fund had proven to beat the S&P 500. How did they perform after the story was published? Over the next five years, they lagged their benchmark indexes by 2.31 percent per year.
But let’s get back to that original Barron’s story. In 2015, they identified nine funds with winning track records over the previous 1, 3, 5, 10 and 25 year periods. Three months later, just 4 of the funds maintained their winning ways. Twelve months after that, those remaining winning funds lagged the U.S. market over the past 1, 3, and 15 year periods.
In a taxable account it would have been even worse. Tax-deferred accounts have annual contribution limits. Big savers often invest more. They invest the surplus in taxable accounts.
If actively managed funds don’t make sense in tax-deferred accounts, the silliness is doubled when the investments are in taxable accounts. Here’s why. Active fund managers trade their fund holdings every year. When they realize a capital gain, their investors pay the bill. Instead of realizing gains at the lower long-term capital gains rate, actively managed funds often realize short-term gains that are taxable at higher rates. They hold many of their stocks for less than 12 months.
Morningstar estimates 15-year after-tax performances for three of Barron’s four “market beating” mutual funds. (Morningstar doesn’t list a post-tax performance for the worst 15-year performer, Harbor Capital Appreciation Fund). The top three funds averaged a compound annual return (after taxes) of 5.07 percent over the 15 year period ending December 31, 2016.
Index funds are a lot more efficient in taxable accounts. There’s little active trading, so they make a lot more money after taxes. Vanguard’s Admiral Series U.S. Stock Market Index (VTSAX) and its S&P 500 Index (VFIAX) averaged compound annual returns (after taxes) of 6.88 and 6.21 percent per year, respectively, over the same time period.
That’s a lot better than Barron’s super funds. If $10,000 were invested in Vanguard’s U.S. Stock Market Index (VTSAX)15 years ago, it would have grown to $27,129. If it were invested in the cherry-picked portfolio of Barron’s “winning” funds, it would have grown to just $20,998.
Investment rules are simple. They’re also timeless. Ignore stories that list “the top winning funds to buy now!” Instead, build a diversified portfolio of low-cost index funds.
Barron’s Winning Funds Stumble
Time Period Ending December 31, 2016
|Fund||1 Year||3 Year||5 Year||10 Year||15 Year|
|Eaton Vance Worldwide Health Science Fund (ETHSX)||Pre-Tax Returns||-14.89%||5.53%||14.43%||9.5%||6.99%|
|Post Tax Returns||-21.96%||0.25%||9.43%||6.31%||4.88%|
|Elfun Trusts (ELFNX)||Pre-Tax Returns||6.08%||6.87%||14.84%||7.72%||6.44%|
|Post Tax Returns||3.71%||4.63%||12.62%||6.13%||4.95%|
|Harbor Capital Appreciation (HCAIX)||Pre-Tax Returns||-1.43%||6.08%||13.54%||7.61%||5.88%|
|Post Tax Returns||-2.82%||4.52%||12.37%||7.05%||N/A|
|Parnassus Fund (PARNX)||Pre-Tax Returns||13.45%||9.26%||17.15%||9.65%||6.51%|
|Post Tax Returns||12.72%||6.84%||14.38%||8.08%||5.39%|
|Vanguard Total Stock Market Index (VTSAX)||Pre-Tax Returns||12.66%||8.38%||14.62%||7.23%||7.31%|
|Vanguard S&P 500 Index (VFIAX)||Pre-Tax Returns||11.93%||8.84%||14.62%||6.94%||6.68%|
|1 Year||3 Years||5 Years||10 Years||15 Years|
|Barron’s Super Funds||Average Pre-Tax Returns||0.80%||6.93%||14.99%||8.62%||6.45%|
|Average Post-Tax Returns||-2.08%||4.06%||12.2%||6.89%||5.07%*|
|Vanguard’s U.S. Index Funds||Average Pre-Tax Returns||12.29%||8.61%||14.62%||7.08%||7.0%|
|Average Post-Tax Returns||11.51%||7.89%||13.93%||6.60%||6.55%|
|Source: Morningstar.com *No available post-tax 15 year return for this fund|
Andrew Hallam is a Digital Nomad. He’s the author of the bestseller, Millionaire Teacher and The Global Expatriate's Guide to Investing: From Millionaire Teacher to Millionaire Expat.