When Morningstar CEO Don Phillips, head of a widely followed fund analysis and rating firm based in Chicago, spoke in Florida March 11, the Nasdaq Composite Index had just rocketed to a record high of 5,048.62. Caught in the euphoria, many investors pulled their money out of “dumb” mutual funds to dive headlong into technology and Internet stocks.
But 5,048.62 was as high as the Nasdaq would go. By the time Phillips spoke again in Coral Gables, Fla., this month, the tech-heavy Nasdaq had fallen below 3,500 and visions of a Nasdaq 6,000 have been replaced by the reality of a tech wreck.
But maybe that’s not all bad.
“I think it has been an interesting and humbling time for individual investors,” Phillips told the Miami-Dade chapter of the Financial Planning Association, the national membership group for financial professionals.
It has been a particularly humbling time for those who chased after erstwhile red-hot Nasdaq stocks. While the overall market has been in a funk for months and all major indexes are down for the year, the average diversified stock mutual fund was up nearly 6.5 percent through Sept. 30.
And many “value” funds, or those that focus on stocks with low price-to-earnings and price-to-book ratios, were sporting double-digit gains.
So perhaps diversification, taking a long-term investment approach and paying attention to valuations — notions that seemed to have been cast aside in the tech mania — do matter after all.
“I am glad to see all these things vindicated,” Phillips told the financial planning group.
It also has been a vindication for Phillips, who often seemed to be a lonely voice at investment conferences.
He — and I — felt that the message from many other speakers was that mutual funds are for idiots and that all you had to do was plunk down your money in a few big-name Nasdaq stocks and perhaps “a couple of pure play Internet stocks, presumably for diversification.”
And then there was a friend who late last summer asked Phillips why he bothered tracking mutual funds for a living when she was making a ton of money with her Cisco Systems stock.
True, Cisco has been an exceptional performer over the years. But, as it turned out, her portfolio also included shares of TheStreet.com Inc., which has suffered devastating losses, and other losers such as Petsmart Inc.
So the friend’s average compounded rate of return for the past three years was actually only 12 percent, “compared to 18 percent for the `dumb’ mutual fund managers,” Phillips said.
“Investors have incredibly selective memories,” Phillips said, and tend to remember only the winners in their portfolios.
So what is Phillips saying? Not that individual stocks have no place in your portfolio, because they do. Morningstar recognizes the fact by providing analysis on stocks as well as mutual funds, although funds are clearly the franchise. What Phillips is saying is that picking stocks is not the child’s game investors may have believed it was at the height of the bull market.
“The reality is, picking stocks is hard,” Phillips said.
If you don’t believe it, consider that in 1999, while the Nasdaq soared 86 percent and the Standard & Poor’s 500 Index rose 21 percent, 52 percent of all stocks traded in the United States went down.
And 32 percent of all stocks, or nearly a third, went down more than 20 percent. Large gains by a few stocks drove the indexes higher, and investors who bet on the wrong stock ended up with large losses.
Yet less than one-half of 1 percent of all mutual funds, which typically invest in a diversified portfolio of securities, lost more than 20 percent.
“That’s not an argument for active management,” or having fund managers pick the stocks rather than simply mimic an index, Phillips said. “But that’s an argument for diversification,” or spreading the risk.
Many investors are not properly diversified today, even if they own more than one fund, Phillips said. Too often they are simply chasing after the latest hot performers or buying funds that invest in the same sector of the market.
“I think today, by and large, people buy good mutual funds,” Phillips said, which was not always true in the past. “But even though one sees good funds out there, there are some rotten portfolios that investors are assembling.”
These “rotten” portfolios result when investors don’t pick funds that complement one another, or don’t know what securities are in their funds’ portfolios, and end up buying funds with the same or very similar holdings.
“Investors often have no idea how to use funds in a portfolio,” Phillips said. “We need to elevate the debate from whether a fund is `good’ or `bad’ to whether it is appropriate or inappropriate as part of a diversified portfolio designed to meet an investor’s needs.”
