Evaluating Equity Mutual Fund Recommendations

I’m a charter subscriber to the Consumer Reports Money Advisor (CRMA) newsletter and I just received the August 2009 issue.  The CRMA is a very informative newsletter that I always read cover to cover and I highly recommend it to anyone who wants the straight talk on personal finance (I have no affiliation with CRMA).

In their monthly “Money Lab” article entitled “Time to Move Back into Stocks?”, CRMA discusses how it may be time for folks who were severely hurt by the recent market downturn (and perhaps left the markets) to pick themselves up, dust off, and start looking at the stock market again.  Waiting for someone to sound the all-clear sign is not going to happen, and if you wait until everything “feels” good, you’re going to miss out on some of the most important gains of the economic recovery, which usually come in the first 12-18 months.

The article goes on to list five large capitalization funds (large caps) and five small capitalization funds (small caps) as standouts.   Now I normally don’t like to promote or recommend anyone rely on a magazine or a newsletter’s choices for investments, but I trust the CRMA more than other consumer publications.  For most people, the funds that are right for you can only be determined with a careful assessment of your goals, risk tolerance and investment time-frame.  Once these items are known, a proper asset allocation can be constructed.

But I was curious to see how CRMA’s choices stacked up with a methodology that I use to screen funds for my own clients.  So I popped the names of the funds into my research tool, ran an research report on them and I present my observations here.

First, the screen criteria listed for the CRMA choices were:

  1. The funds consistently outperformed their peers (but no period or specific criteria were listed).
  2. Funds had managers that had run them for at least 4 years.
  3. The funds have an expense ratio of no more than 1.4% for small caps (the average expense ratio for small caps is 1.54%) and no more than 1.27% for large caps (1.27% is the average for large caps).

Their choices and a few observations:

Small Caps

Name Ticker Morningstar
Buffalo Small Cap BUFSX Small Growth
Neuberger Berman Genesis Inv NBGNX Small Blend
Queens Road Small Cap Value QRSVX Small Value
Royce Special Equity Invmt RYSEX Small Value
TCW Small Cap Growth I TGSCX Small Growth

From this list, the Royce Special Equity Invmt (RYSEX) and Neuberger Berman Genesis Inv (NBGNX) were on my preferred list of small cap funds.  The rest were not, so I was only batting 0.400.  Naturally, I wanted to know why the rest didn’t make my list.

Queens Road Small Cap Value (QRSVX) did not make my list because it does not have a 10 year history, has only $22M in total assets and a somewhat higher (though still below average) 1.35% expense ratio.  I generally like to see a fund with a 10 year history, at least $50M in total assets and a low expense ratio that matches its best performing peers.

Although TCW Small Cap Growth I (TGSCX) ranked highly for performance compared with its peers for 1, 3 and 5 years, it was ranked in the bottom 15% of funds in its class for the 10 year period ending June 30, 2009.  Though 10 years is a long time, there are funds in this category that make the grade for all periods.  In addition, although TGSCX had a high return rating, it also came with a high risk ranking, and I generally avoid high risk funds, especially when there are funds that generate high returns with lower risk factors.

At first glance, the Buffalo Small Cap fund (BUFSX) revealed that it was outstanding in most respects, so I was puzzled why it wasn’t on my preferred list.  Looking at all the criteria, the fund risk was a bit higher than others but not the highest in the group.  This fund makes big sector bets which can go awry and cause short-term performance problems.  The fund has a 2% redemption fee if you cash out in 180 days or less.  Nonetheless, in the small cap growth space, this is a fine choice.

Large Caps

Name Ticker Morningstar
Yacktman YACKX Large Value
Parnassus Equity Income – Inv PRBLX Large Blend
Fairholme FAIRX Large Blend
Aston/Montag & Caldwell Growth N MCGFX Large Growth
CGM Mutual LOMMX Large Growth

From the above list, only Parnassus Equity Income – Inv (PRBLX) is on my preferred funds list for large cap funds.   The rest were not, so I’m batting 0.200 in this category.

Yacktman (YACKX) is ranked #1 in its category for all period rankings (1, 3, 5 and 10 years), but it does not make my preferred list due to above average risk for the past five years.  It also has a 2% redemption fee if you cash out in 30 days or less.  The managers run a concentrated portfolio (currently 31 stock holdings), which can add to volatility and performance swings over time.  The fund’s propensity to hold cash (20% last year) can hamper the fund when the market is roaring, though it helps in down markets.  In most respects, this is a good fund.

Fairholme (FAIRX) is not on my list because it doesn’t have a 10 year history (currently stands at 9.5 years) and fund’s five year risk is high.  It also has a 2% redemption fee if you cash out in 60 days or less. This fund concentrates its picks in individual sectors and is a highly concentrated portfolio (currently 21 stocks), with top positions representing as much as 15% of assets. Otherwise, it’s ranked #1 in its category for all periods.

Aston/Montag & Caldwell Growth N (MCGFX) is in the top 35% of funds for the 10 yr category ranking.  The managers run a concentrated portfolio (currently 31 stock holdings), which can add to volatility and performance swings over time.  This is the only fund in the recommended group that charges a 0.25% 12b-1 (marketing) fee.  It is a fine fund, but with such a wide universe of large growth funds, you can do better.

CGM Mutual (LOMMX) has excellent 3, 5, and 10 year rankings, but its 12 month category ranking was in the bottom 16% of large cap growth funds.  The 5 year fund risk is above average, so it doesn’t make my list of preferred large cap growth funds.  Year to date, it’s in the bottom 2% of similar funds and is the only fund in the recommended group that has a negative return (-1.27%).  While long term performance is what matters most, I can’t overlook the short term under-performance.  The fund also has concentrated holdings (only 15 stocks and 7 bonds).  Although it’s classified as a large cap growth fund, the prospectus objective is a balanced fund (stocks and some bonds).

Please keep in mind a couple of things when using the forgoing information: 1. This is not an endorsement or recommendation for any particular fund; 2. Fund performance, managers, expenses, operations, etc. change on a daily basis, so a fund that looks great today, may not look so good next week or next month.  With this in mind, if you are managing your own investments, you should be sure to review your choices at least once a year, preferably when you are re-balancing your investments, to ensure that they still meet the objectives you had when you bought them.

Overall, my objective here was not to criticize or praise the choices of the CRMA.  While these funds are good choices in general, knowing more about them can help you decide whether they are appropriate for your portfolio.

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