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Lessons to Learn From Mutual Fund History
by Paul A. Merriman Publisher and Editor
An article on the history of mutual funds in the April 1999 issue of Money magazine sent me to the shelves of our in-house library, where I was pleased to find a dusty volume entitled "Common Stocks as Long Term Investments," by Edgar Lawrence Smith.
Smith, by the way, is credited with first identifying some technical cycles that have held up well although he could never explain them. For instance, Smith observed that years ending in "7" have the worst returns, while years ending in "5" have by far the best returns on average. Throughout the 20th century, the stock market has risen in every year ending in a "5."
If you’re lucky, you might be able to find this small book at your public library or at an antiquarian book store. (We couldn’t find it at Amazon.com’s online bookstore.) If you have any doubts about how much the world has changed in the past 75 years, Smith’s words are a stark reminder.
He expresses wonder at the rise of modern conveniences such as better heating, lighting and plumbing, "automobiles instead of buggies" and "telephones, radios and so on down the list of things we have today that were unknown to our fathers." He then complains about how much money the states are spending on building highways: "It is the day of the automobile, whose private extravagances are forcing a public extravagance in due proportion."
The book, 129 pages including Appendix, seems pretty dull today. Essentially it makes the case that common stocks are a better investment than bonds. Well, duh!
But wait! When this book was published in 1924 by The Macmillan Company, with a cover price of $1.50, that was a controversial, even revolutionary, thesis. Smith’s research was revolutionary. The front of the book jacket quotes a reviewer in The Independent as saying: "It will astound many that the results (of Smith’s studies) are so favorable to common stocks."
Smith’s book became a best-seller, but not until 1929. The book is worth reading even now because his pioneering research helped change forever the way many investors looked at the stock market.
You may think of the "Roaring 20s" as a time of free-wheeling speculation. But Smith’s book paints a different picture as it describes the conventional wisdom of the day. Prudent investors, he said, focused mostly on the merits of high-grade bonds. "Those who venture to suggest preferred stocks sometimes feel that they have gone as far as conservative opinion will support them. Common stocks are, in general, regarded as a medium for speculation, not for long term investment."
To challenge that idea, Smith presented the results of a series of hypothetical investment portfolios between 1901 and 1922, comparing common stocks and high-grade bonds. There were no computers and no index funds back then, so Smith had to keep things simple. He chose 10 individual stocks for each portfolio in a manner he described as "a hit or miss policy which could only be regarded as reckless. We assumed that (an investor) had only $10,000 and we made him pick out the 10 industrial common stocks" with the highest trading volume in the preceding week.
In a dozen tests over various time periods, Smith found 11 stock portfolios outperformed the bond portfolios. Smith tried similar comparisons with stock portfolios chosen by several other means, and the results were consistent: Stocks outperformed bonds.
He did a similar series of tests of returns from 1866 through 1899, assuming that a hypothetical investor lived in Boston "and was subject to the influences of the Boston financial psychology of the time.
"It is beyond all question that in 1866 in Boston, he would think first of cotton mill stocks, representing the great New England industry of the time," Smith wrote. Therefore, his hypothetical investor bought into three of the largest cotton mills, Amoskeag, Pacific Mills and Merrimack. The investor also bought stock in two gas lighting companies, one in Boston and one in Cambridge, and in horse-drawn railways in Boston and Cambridge.
Smith said his first hypothetical tests "tend to show that well diversified lists of common stocks selected on simple and broad principles of diversification respond to some underlying factor which gives them a margin of advantage over high-grade bonds for long-term investors." But, he said, stocks are known to be so speculative "that we are hardly justified in accepting stocks as an alternative to high-grade bonds for long-term investment unless we are able to isolate this underlying factor" and determine if it is likely to keep working in the future.
So he undertook further studies and put together a chart that tracked a hypothetical $5,000 investment in a diversified group of common stocks for 86 years, from 1837 to 1923. This chart, he said, for the first time explained why every previous 20-year test resulted in stock gains. His conclusion was radical in his day: Stock investments not only pay dividends that are higher than the yield of bonds; stocks also can be expected to appreciate in price over time.
That, he said, is the "force" behind his studies. And he said that force resulted from the fact that companies used part of their profits, the part that they didn’t pay out as dividends, to reinvest in the companies themselves. This seems obvious now, but apparently it was not generally recognized at the time.
Ever the curious student of statistics, Smith observed that the rate of stock appreciation was "measurably close to the rate at which the population of the United States has increased since 1820, which averages 2.43 percent per annum. Whether national growth is the cause or the result of successful industrial expansion may never be known, but the two work hand in hand in favor of equity values as represented by shares of stock."
Then, in a comment that would be equally relevant in 1999, Smith said another factor favoring stocks was "the constantly accelerating speed of modern life. All our activities are on a much more rapid basis today than they were 20 years ago, due in part to the constant increase in the speed of communication and transportation and the countless time-saving devices that have been introduced into our business and private life. … All this acceleration favors carefully selected and diversified common stocks as opposed to bonds."
Finally, Smith proposed another extremely radical idea. He noted that stockholders were getting a premium income return, above what they would receive in high-grade bonds. "Let us grant our investor the right to spend only the amount he would have received from an investment in bonds," Smith wrote. He then assumed that the investor had reinvested the rest of his income in his stock portfolio. In other words, reinvestment of dividends. He characterized this practice as "investment management," as opposed to simply investment, and called it "an essential part of any investment policy which contemplates the purchase of common stocks."
Using 86 years of data, Smith calculated the odds of at least breaking even in a diversified group of common stocks as 78 percent in one year, 87 percent in two years and 94 percent in four years.
(Those observations have held up for at least 75 years after Smith’s book came out. Since 1926, investors who bought the S&P 500 Index and held it for five calendar years at least broke even more than 90 percent of the time.)
Unfortunately, there are exceptions. And as we shall soon see, some investors who followed Smith approach got burned as a result.
The same year Smith published his book, Edward G. Leffler invented the world’s first open-end mutual fund, Massachusetts Investors Trust. (An open-end fund is one that sells shares directly to investors and buys them back. This is the model for most mutual funds today, and a fund’s size can grow or shrink depending on how many investors it attracts. A closed-end investment company, by contrast, issues a fixed number of shares, which then trade on a stock exchange.) Massachusetts Investors Trust attracted 200 shareholders in its first year and grew to $392,000 in assets.
In 1925, Smith founded Investment Trust Fund A, a closed-end fund that followed the teachings in his book. But six years later, in 1931, this fund was down about 75 percent from its initial value. Though precise information is not available, it’s safe to say that only part of that loss came from a decline in the value of the fund’s portfolio. Much of it probably came from a change in investor sentiment that resulted in the fund’s selling at a huge discount from its net asset value, or NAV. Here’s where it really pays off to know the difference between closed-end and open-end funds.
If you sell shares of an open-end fund, you’ll always get the NAV per share (less any redemption fee) for them. The NAV rises and falls based only on the value of the fund’s portfolio. But in a closed-end fund, supply and demand determine the price at which investors buy and sell. Closed-end funds almost always trade at a discount or a premium from NAV.
When investors are highly optimistic, closed-end funds can sell at a substantial premium. This was especially common when these funds were the only way individuals of modest means could invest in a diversified portfolio with professional management. In the fever-pitch 1920s, closed-end funds sometimes traded at premiums of 30 percent or more over their NAV. Some fund companies charged expenses of 12.5 percent of their NAV, and many refused to disclose what was in their portfolios. (This reminds me of last year’s Long Term Capital Management fiasco.)
But after the great stock market crash from 1929 to 1932, investors weren’t so eager to jump on the closed-end-fund bandwagon. By 1932, sentiment was so sour that many closed-end funds were trading for only 10 percent of the value of their underlying assets.
In retrospect, that was a terrific time for patient investors to snap up these funds at bargain prices. When stocks recovered over the next few years, fund investors not only gained indirectly as portfolio values rose, but gained again as the discounts shrank. For instance, suppose you could buy into a closed-end fund with an NAV of $10 for only $1 a share. If the NAV subsequently rose to $15 and the discount shrank to 20 percent, the shares would be worth $12 each.
That’s the extra opportunity in closed-end funds: you can benefit from a falling discount or a rising premium. But of course it works the other way, too. If investor sentiment, for whatever reason, turns bearish, you may have to sell a closed-end fund for a smaller percentage of the NAV than you paid for it. This makes closed-end funds particularly tricky and difficult.
Smith was ahead of his time in his investment philosophy. But ironically, because he stuck to the older model of investment company, the closed-end fund, many of his ardent followers were badly burned by the market.
Here are some other highlights that I found interesting in the Money mutual fund history:
This look at mutual fund history showed me a few things that probably seemed minor at the time, but that turned out to be pivotal events. In 1958, for the first time, the dividend yield on stocks dropped below the yields on long-term bonds. To modern investors, this may seem puzzling. Why wouldn’t the dividend yield on stocks always be lower than those of long-term bonds? Dividends don’t play a big part in stock prices these days.
Today’s investors don’t want dividends. They want companies to reinvest all their profits in building their business, developing new products, clobbering the competition. If Microsoft Corp. announced it was going to start paying a dividend, the stock would probably fall 20 percent in a day or two. But as Smith’s book makes clear, dividends used to be an essential part of the attraction of stocks.
The conventional wisdom on Wall Street in 1958 said that the yield relationship between stocks and bonds would soon return to normal – which was defined as higher for stocks than bonds. But that "return to normalcy" never happened, and bond yields are still higher than those from stocks. Investors, of course, still usually obtain higher total returns from stocks than bonds because total return is the sum of a price change and income.
Here’s where this gets interesting. If we are still waiting for the dividend yield to return to normal levels, what else are we waiting for and expecting? Are we expecting the P/E ratios of stocks to return to "normal" levels of 14 to 16 times earnings? Are we expecting the Standard & Poor's 500 Index to return to a "normal" growth rate of 10 to 12 percent? Are we expecting small-cap stocks to return to their "normal" practice of outperforming large-cap stocks? Are we expecting value stocks to once again outperform growth stocks, as they did for most of the past 70 years?
Templeton was practicing what is known as value investing, buying securities that relatively few others want, seeing potential where others see problems.
Only time will tell whether international investing and value investing will return to favor and recapture the imagination of investors. Personally, I still believe in both. Each one just makes great sense to me: spreading your risks and seeking rewards throughout the world, and buying assets that are out of favor.
Yes, there’s always some reason those assets are out of favor, and no, they don’t always "come back." But I keep returning to the most fundamental slogan of investing: Buy low, sell high. You can’t buy low if you wait until everybody agrees that an asset is safe and reliable. To buy low, you have to buy what others don’t want. That’s not easy, and it’s one reason so many investors fail to get the returns they could.
We like to rely on academic research for many of our recommendations, and we think it’s valid. But sometimes the professors are dead wrong. You’ve heard the one about the business professor who gave Fred Smith a failing grade on a college paper that outlined a nationwide overnight delivery service. The professor said Smith had failed to describe a plan that was feasible. Smith thought otherwise, and he founded a company called Federal Express. He must have enjoyed the irony of sending one of the first Federal Express packages to his old professor.
In mutual fund history, in 1968, Michael Jensen, an economics professor, wrote a paper in the Journal of Finance entitled "The performance of mutual funds." He argued that most funds, over time, could not perform well enough to recover their costs of doing business. Nobody paid any attention.
In 1974, Paul Samuelson, whose economics textbooks were standards for a whole generation of college students, wrote a paper saying most mutual fund managers "should go out of business" and do something useful such as "take up plumbing." Another bad academic call.
That same year, quite a bad one for the stock market, Wellington Management Company fired a manager named John Bogle. Bogle opened up his own mutual fund shop, naming it Vanguard Group. Two years later, he invented the retail index fund, now known as the Vanguard 500 Index.
The 1970s and 1980s included the first money-market fund, the first fund with a check-writing feature, the rise and collapse of junk bond funds, technology funds and mortgage funds, not to mention the advent of the 401(k) and the IRA retirement plans.
To me, one of the biggest lessons from all this is how much things change over time. This article reminds me that major "paradigm shifts" do indeed happen in the markets. Relatively few people recognize them in the beginning, and those people are often regarded as kooks.
Who in 1981, for instance, would have believed any prediction that within 15 years a tiny supplier to the gigantic IBM Corporation would in the next 15 years become larger than IBM itself? I doubt that even Bill Gates imagined any such thing back then.
The history of investing is littered with the names of people who predicted "new eras" and paradigm shifts that turned out to be little more than pipe dreams. But times do change. A hundred years ago was "the day of the railroad." Seventy-five years ago was "the day of the automobile." Today we might predict that history will call the late 1990s "the day of the computer" or even "the day of the Internet." But we are far too close to the situation to see it as clearly as our children and grandchildren will. I’m sure that in 25 years from now, some of the things we take very seriously today will seem silly.
Here’s the great paradox of investing: You can know the past, but you can’t invest in it. You can invest in the future, but you can’t know it.
The keepers of the conventional wisdom usually can’t see the future very clearly. Again and again, some of the brightest minds in finance have been dead wrong. And yet, time after time, a few equally bright minds have managed to not only visualize a future, but to help create it. If you believe you have some insight into the future, look for ways to invest in what you foresee. That’s one of the great opportunities that comes with having excess capital.
If you are right, you could make a lot of money. Just don’t bet your life savings on it.
Source: http://www.fundadvice.com
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