Morningstar recently issued a report regarding the performance of the
CGM Focus mutual fund. They reported how this fund was the decade's
best performing mutual fund, rising more than 18% annually, yet
investors in the fund experienced a yearly loss of 11% during this same
period. How could this be?
CGM Focus Fund illustrates the issues with mutual funds that have
excessive "turnover". Turnover is the rate at which a fund's holdings
change every year. A turnover rate of 50% means that half of the stocks
held by a fund are completely replaced within one year. The typical
managed mutual fund has a turnover rate of 85%. Index funds, which hold
all the stocks in a stock market index and do not sell unless the index
itself changes or in order to generate cash for redemptions, typically
have turnover rates in the single digits. According to Morningstar, CGM
Focus's turnover rate is an astonishing 504%, meaning that its entire
portfolio is replaced five times over the course of a single year!
In addition to generating excessive taxable gains in non-deferred
accounts and driving up trading related costs, high turnover funds are
very volatile. Due to their volatility, the actual return experienced
by fund investors is often lower than the internal return of the fund
itself because the fund’s volatility increases the likelihood that
investors will buy and sell at inopportune times.
When asked about the great disparity in fund versus investor
performance, CGM Focus Fund's manager Ken Heebner replied, "A huge
amount of money came in right when the performance of the fund was at a
peak. I don't know what to say about that. We don't have any control
over what investors do."
I would argue that, while a fund manager may not be able to control
investor behavior, any fund manager realizes that increased volatility
also increases the likelihood that investors will buy high and sell
low, and pay more in the process. John Bogle, the Founder of the
Vanguard Group, Inc., certainly feels differently than Mr. Heebner. In
a recent interview, Mr. Bogle rails against "...funds (that turn) over
at 100% or 200% annual rates, leading, among other things, to
incredible tax inefficiency." He goes on to ask, "Would you do that
with your own money? Do you think those managers would do that with
their own money?"
Like Mr. Bogle, I feel that the best approach is to work with
investments that are low cost, tax efficient and have low turnover as
part of a long term approach aimed at achieving a fair, market rate of
return. The issues raised with the strategy of funds like CGM Focus illustrate
why a "market return" approach is appropriate for most clients
and is in fact the only approach compatible with a fiduciary standard
of care that places client's best interests first at all times.