The Existential Angst of the Domestic Equity Diva
In the late 1990s, I found myself seated at the Morningstar Investment Conference next to Morningstar's Don Phillips as famed fund manager Bill Miller of the Legg Mason Value Trust—slayer of the S&P 500, mesmerized the audience with a height-of-the-dotcom-boom presentation on why Amazon was a value stock.
As Phillips remembers it, another famed value manager, David Dreman, shot back at Miller that his arguments about Amazon assumed everyone in the world and on worlds yet to be discovered would use Amazon's service.
Miller was right (additional planets notwithstanding) about Amazon, but just about everything else has gone wrong for the mutual fund industry's actively managed domestic equity fund legends of yesteryear.
Mutual funds used to worry about losing their star managers to hedge funds, like Jeff Vinik of the Fidelity Magellan Fund (now owner of the Tampa Bay Lightning). Now, they don't have time to worry about losing stars to hedge funds or even the owner's arena luxury box, but about the rise of ETFs, low-cost index funds, and the reams of data on the inability of the average active fund to beat the benchmark.
The mutual fund market has come full circle from an era when active managers like Peter Lynch (Vinik's predecessor at Magellan) and Miller walked on water to a world in which the general investor assumption is that an active manager can never beat the market.
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Now, as the stock market extends a multiyear bull market trend but actively managed domestic equity funds don't reap the benefits in a way they would have in past decades, this slow shift away from active funds has given way to a straightforward question:
Can the former divas of the mutual fund world's active funds ever regain their center stage status?
As fund executives meet this week for the 25th Morningstar Investment Conference, the odds seem to be stacked against them. The post-traumatic stress of the financial crisis, skepticism about the financial services industry, and the slow burn of the biggest driver of active managers' success —baby boomers' accumulation of wealth—are all weighing heavily on the future of active management.
In 2007, Miller's Legg Mason Value Trust had upwards of $20 billion in assets. Today it has $2.3 billion in assets. Miller's legendary streak against the S&P 500 long ago ended (in 2006). Legg Mason Capital Management, where Miller was chairman during his glory days, was folded into a larger New York-based investment unit at the beginning of this year, and Miller now manages one fund.
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"The financial crash was the last blow," said Phillips, president of Morningstar's investment research division. "I don't think it can be reversed. Most of the money still in active funds won't be going away soon—but these fund managers have to deliver to a very skeptical audience. Today, there is no longer manager worship," Phillips said. When the assets of the baby boomers are transferred to the next generation, the "jump ball" with index and active facing off, there is every reason to believe the majority will go to passive strategies.
"Money has been locked up [for] ages in active managers," Phillips said, and it's not just the boomers and 401(k)s but also the transition away from the remaining defined benefit plans that ensures the long-term secular trend to passive is firmly in place.
One of the ironies of the faded star of active management is that it's not nearly as bad as it might seem. Take American Funds' Growth Fund of America. There was an impression that the Growth Fund of America was untouchable after it managed to sidestep the tech bubble, but that investment Teflon was quickly scraped away after it failed to avoid the financial crash. "The long-term record on that fund is still outstanding," Phillips said.
In fact, Morningstar recently completed a study showing that among the 15th biggest funds of 20 years ago (14 were active, excluding the Vanguard S&P 500 Fund), six of the 14 have beaten the index and eight trailed in the period (the Growth Fund of America being among the outperformers).
"That's what you would expect in most longer-term time periods," Phillips said. "The reality is that indexing is a really safe way to assure moderately above average outcomes and that's a terrific bet to make, but you won't beat everyone."
In the past year, American Funds' Growth Fund of America ranks 11th among 1,708 funds in its category, outperforming the S&P 500 by 1.64 percent. It has slipped below the S&P 500 return year-to-date.The one fund Miller manages, Opportunity Trust, (which has a much higher expense ratio than average for its asset class at 2 percent) ranks second in its category among over 400 funds in the past year, and has doubled the S&P 500 return year-to-date, up 35 percent.
Bing Waldert, Cerulli Associates director, said, "Domestic equity has been unfairly punished coming out of 2008 and 2009. Look at American Funds' struggles. They haven't done anything wrong on the performance side but are being punished for being the most popular when things went bad."
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Meanwhile, even index funds are being pressured to enhance return with the rise of smart beta and enhanced index as asset classes, and active managers that have had any asset growth have gravitated to the international and emerging market investment areas.
"The outflows from domestic equity are staggering," said Geoff Bobroff, long-time fund consultant. Even in areas where domestic equity managers have weathered the storm, it's only because dividend income funds are attractive to the aging demographic and its risk tolerance. "Firms like Davis [Selected Advisers] and Capital Research and Management's American Funds are faced with significant continued outflows," Bobroff said.
At the beginning of 2000, domestic equity funds accounted for 40 percent of industry assets. It's now down to roughly 23 percent to 24 percent, Bobroff noted. "It's a painful transformation," he added.
In 2007, American Funds had $1.2 trillion in assets, and the Growth Fund of America $179 billion. Today, the Growth Fund of America has $123 billion in assets. While that still makes the fund larger than most fund companies, it's declined at an even faster clip than the domestic equity category. And in the not too distant future, the fund's "sticky" assets—it is among the most heavily marketed retail funds and supported by the large broker/dealer firms—may become part of the "jump ball" asset grab.
"There is continued concern that passive investing is a secular shift, not a short-term phenomenon," said Cindy Zarker, director at Cerulli. That's a statement that could easily be interpreted as understatement. Or, it could reflect how stubborn the mentality of the domestic equity active manager is, even after having been spurned by investors in the post-crisis bull market.
Phillips said that among active managers, Miller always accepted the challenge of the index and even remarked that beating the market could be luck, and conceded that the index does a lot of things very well. But not all active managers were as understanding, either during their heyday or as their heyday gave way, though most of their fates have mirrored Miller's.
"The first step for active managers is to admit they have a problem. They really need to get their act together. I think they are closer to admitting the problem than they were 20 years ago," Phillips said.
Once upon a time in America, there were arguments—"bogus puffery" Phillips calls it—that it was un-American to use index funds because it implied Americans were settling for mediocrity. "People just dismissed indexing once upon a time."
In fact, you could say, the same way they dismiss active managers today.
—Eric Rosenbaum, CNBC.com