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.