Mutual Funds Probably Should Stay Open
Thursday, February 20, 2014
Charles Rotblut, CFA
AAII Journal Editor

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Sentiment Survey

This week’s AAII Sentiment Survey results:
  Bullish: 42.2%, up 2.1 points
  Neutral: 35.0%, down 2.5 points
  Bearish: 22.8%, down 4.6 points

Long-term averages:
  Bullish: 39.0%
  Neutral: 30.5%
  Bearish: 30.5%

Take the AAII Sentiment Survey »

Yacktman Focused (YAFFX), a fund we recently deleted from the AAII Model Fund Portfolio, is one of a relatively small group of value-oriented mutual funds to close last year. When a mutual fund closes, it either stops accepting investment dollars from new investors or stops accepting any new investment dollars, be it from new or existing shareholders. Some funds may partially close by removing themselves from broker networks and requiring new investors to directly go through the fund. The latter is what the Sequoia Fund (SEQUX), which I own, did for a while before completing closing its doors to new investors at the end of last year.

Mutual funds, like many other investment products, earn money based on a percentage of assets managed. In concept, a mutual fund manager would want his assets under management (AUM) to be as high as possible to maximize his profits. With the average domestic large-cap fund charging nearly 1% in annual expenses, every extra billion dollars' worth of AUM adds up to a lot of profits.

In practice, there can be a limit to what level of AUM makes sense. A fund manager with a very targeted strategy can end up with more investment dollars than good ideas. This is particularly the case if a fund invests in a country with a comparatively small securities market or follows a restrictive strategy. It can also make sense to place a cap on a fund's AUM to prevent it from becoming so large that it is difficult to do anything but essentially mimic an index fund, albeit at a higher cost.

Funds may close, however, because a manager simply believes the prevailing market environment doesn't offer enough attractive investment opportunities. Investors may see a preliminary sign that this is occurring by monitoring the fund's cash balance. For example, Yacktman Focused ended 2013 with a 20.8% cash allocation, up from 16.3% a year prior.

Alternatively, a fund manager may simply raise or maintain a high cash allocation because he thinks there isn't much in the way of good ideas. Longleaf Partners Fund (LLPFX) doubled its cash allocation from 7.4% at the end of 2012 to 15.0% at the end of 2013. To put the fund's cash allocation into perspective, the average cash balance for large-cap funds in the print version of our Mutual Fund Guide designated as either value or growth and value was 2.87% at the end of last year versus 2.85% at the end of 2012. (Longleaf Partners Fund still remains open to new investors.)

The obvious question is: Is any of this good for investors? Probably not, but with some exceptions. (Investing is messy, after all.) Logically, it would make sense for a manager who is investing in a smaller segment or a smaller country to limit inflows when too many new investors want in. It would also seem to make sense to close a fund whose size puts it at risk of mimicking a lower-cost index fund. Conversely, raising cash levels because the manager does not perceive enough investment opportunities exist is far more debatable. Doing so puts the manager in the realm of market timing, something most investors—individual and institutional—have failed to successfully accomplish on a consistent basis.

I looked for studies about how mutual funds performed after they closed and only found a few analyses. The consensus among those studies is that there has not been a benefit to the fund's shareholders. Historically, mutual funds have not maintained their outperformance after closing to new investors. This finding supports a belief that Jim Cloonan will express in next month's AAII Journal: Closing a fund to new investors has a negative effect.

An Addendum to Last Week's Commentary

Last week, I discussed looking at last year's cheapest stocks, as ranked by price-to-book ratio, for this year's potential winners. A few days ago, Jim pointed out that I overlooked the exclusion of financial stocks by Eugene Fama and Kenneth French in their study. The two made this exclusion because financial companies' balance sheets are structured differently than companies in other sectors, particularly when it comes to leverage. I should have caught that distinction myself, especially since it would have narrowed my list of passing companies considerably.

AAII Model Portfolios

Yacktman Focused (YAFFX) was deleted from the Model Fund Portfolio and replaced by Fidelity OTC fund (FOCPX). Yacktman Focused was reaching the size where it would become a closet index fund and the 1.25% expense ratio was just too high. The Yacktman fund was one of three holdings in the Model Fund Portfolio closed to new investors. The other two are Aston/Fairpointe Mid Cap N fund (CHTTX), which closed last quarter, and FMI Common Stock fund (FMIMX), which closed at the end of 2009. For those using the Model Fund Portfolio as a guide for their investments, these two funds should continue to be held by those who currently own them. Anyone currently not owning them and therefore unable to buy them should simply use the remaining seven funds in the portfolio.

During January, the Model Shadow Stock Portfolio lost 7.6%, underperforming both the Vanguard Small Cap Index fund (NAESX), which lost 2.1%, and the DFA US Micro Cap Index fund (DFSCX), which fell 4.4%. The Model Shadow Stock Portfolio has a compound annual return of 17.8% from its inception in 1993, while the Vanguard Total Stock Market Index fund (VTSMX) has gained 9.1% annually over the same period.

The Model Fund Portfolio held up better, losing 2.0% in January, and the Conservative Portfolio (75% Model Fund Portfolio and 25% iShares Barclays 1-3 Year Treasury Bond ETF (SHY)) was only down 1.5%. This compares to a 3.1% loss for the Vanguard Total Stock Market Index fund (VTSMX). The Model Fund Portfolio has a compound annual return of 9.3% from its inception in June of 2003, while the Vanguard Total Stock Market Index fund has gained 8.8% annually over the same time period.

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The Week Ahead

Retailers will be in the spotlight as fourth-quarter earnings season starts to wind down. The Home Depot (HD) will be the only member of the Dow Jones industrial average to report, with a Tuesday release date. Joining it throughout the week will be more than 40 members of the S&P 500, including Lowe’s Companies (LOW) and Target (TGT) on Wednesday.

The first economic reports of note will be the Conference Board’s February consumer confidence survey and the December S&P Case-Shiller Home Price Index. Both reports will be released on Tuesday. Wednesday will feature January new home sales. January durable goods orders will be released on Thursday. Friday will feature the first revision to fourth-quarter GDP, the final February University of Michigan consumer sentiment survey, the February Chicago Purchasing Manager’s Index and January pending home sales.

The Treasury Department will auction $32 billion of two-year notes on Tuesday, $35 billion of five-year notes on Wednesday (there is a special note PDF about this auction on and $29 billion of seven-year notes on Thursday. Additionally, $13 billion of two-year floating rate notes will be auctioned on Wednesday.

AAII Sentiment Survey

Optimism rebounded for the second consecutive week, but remains below the levels registered at the start of the year, according to the latest AAII Sentiment Survey. Pessimism, meanwhile, fell to levels not seen since mid-January.

Bullish sentiment, expectations that stock prices will rise over the next six months, rose 2.1 percentage points to 42.2%, a six-week high. The historical average is 39.0%.

Neutral sentiment, expectations that stock prices will stay essentially unchanged, rebounded by 2.5 percentage points to 35.0%. This is the seventh consecutive week with a neutral sentiment reading above its historical average of 30.5%.

Bearish sentiment, expectations that stock prices will fall over the next six months, dropped by 4.6 percentage points to 22.8%. This puts pessimism at a five-week low. Bearish sentiment is also below its historical average of 30.5% for the 20th time in the past 24 weeks.

The above-average reading for neutral sentiment extends a trend that has occurred over the past 12 months. Since February 28, 2013, neutral sentiment has been above its historical average 36 out of 52 weeks (69% of the time). In comparison, bullish sentiment has been above its historical average 25 times and bearish sentiment has been above its historical average 18 times over the same period. The pattern suggests that despite the overall strong performance of the stock market, individual investor enthusiasm for stocks remains reserved.

The rebound in the S&P 500 after its recent pullback continues to alleviate concerns, at least temporarily, among individual investors about whether the market established a short-term top at the start of the year. Also helping to boost optimism are sustained earnings and economic growth, the Federal Reserve’s tapering of bond purchases and the debt ceiling agreement. Keeping some individual investors bearish are worries about the potential for a correction, elevated stock valuations, the pace of revenue growth and Washington politics.

This week’s special question asked AAII members if there are any economic or market catalysts they are looking for over the next few months. No consensus appeared among the answers. Approximately 20% of respondents said they are watching corporate revenue and earnings growth. Slightly more than 17% said the labor market is a key indicator, especially an acceleration in job growth or a decrease in the unemployment rate. Nearly 12% were focused on the general rate of economic expansion. Other respondents said they were monitoring interest rates, foreign economies and Federal Reserve policy.
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