Manager Picking

Where Have All The Geniuses Gone?

Manager Picking

Ken Heebner (not Hebner) is a fund manager`s fund manager--obsessive, cantankerous, eccentric, brilliant. He took over the fund now known as CGM Capital Development in 1976, about the time Peter Lynch began at Magellan. Since then Heebner has produced an average annual return of nearly 20%, vs. 12% for the S&P 500. That`s genuine outperformance over a significant span. Heebner`s confidence (some call it arrogance) is such that he once told a reporter he was interested only in stocks that could beat the market by 50%.

As much as anyone but Lynch himself, Heebner embodied the case for active investment management--living proof that talented, hard-working people really can make your money grow faster than the market. Now in his third decade as a fund manager, Heebner is still the same guy. He still works long hours; still ignores the pack ("I happen to believe owning Internet stocks is reckless speculation"); still seems to be living in his own world much of the time, whether poring over spreadsheets in the elevator on the way to his 45th-floor office overlooking Boston Harbor or scuttling down a hallway with a visitor in tow, oblivious to the wide rip in the seat of his pants.

But the rules of the game have changed. Where Heebner`s portfolios once stood out among a few hundred funds, now they don`t stand out at all, and they`re battling for shelf space with thousands of competitors. In the crush, only funds with the most blistering performance or the most powerful distribution even get noticed, let alone sold. Heebner has little of either. Capital Development trailed the S&P 500 badly in 1997 and 1998; so far this year it has a return of -3%, while the index is up 10%. Heebner was once such a magnet for money that he closed Capital Development to new investors. Now it and all the other funds he manages at CGM, the company he helped found in 1990, are bleeding assets.

Heebner`s fall from grace perfectly captures one of the oddest paradoxes of this strange market: After 17 years of a roaring bull, there are no heroes in mutual fund land.

Lynch is long gone. So is John Neff. Countless other headliners of the past--Robert Sanborn, Eric Ryback, Gary Pilgrim, Bill Sams, and Marty Whitman, to name a few--have suffered the same fate as Heebner: Unable to beat the S&P 500 index, they have lost their celebrity glow.

Where once we saw wizards, artists, financial Michelangelos, now all we see are charlatans. Underlying this is a growing disaffection, bordering on scorn, for the whole undertaking.

Who believes in mutual funds anymore? What used to be the fund industry`s dirty little secret--the failure, year in and year out, of most actively managed funds to outperform the S&P 500--is no secret now.

John Rekenthaler, research director at fund tracker Morningstar, says the actively managed funds are beginning to show up on his cultural radar as a "marketing scam for suckers."

Even Alice, the homeless woman in Doonesbury, has no more illusions. "Jean, have you looked at managed portfolios over the last ten years?" she asked in a strip that ran last fall. "The market beat 87% of them! 87%!"

During the `90s, money has been pouring into unmanaged index funds, led by Vanguard`s mighty 500 Index. No wonder fund company entrepreneur Chris Wiles of the Rockhaven Funds feels besieged. "This used to be a very respected profession," he laments. "How did people come to think we`re all idiots?"

Last May, at the annual convention of the Investment Company Institute (ICI), the fund industry`s trade group, Fidelity Investments President Robert Pozen called the growth of mutual funds over the past two decades "one of the greatest economic success stories of the 20th century." He`s absolutely right. But the century is almost over. And maybe the success story is too.

In case you`ve missed the details of the growth Pozen was talking about, here are some compelling numbers, courtesy of the ICI: Since 1979, the mutual fund universe has expanded from 524 funds (barely enough listings to fill two columns in the newspaper) to 7,521 funds, and from a niche market reaching a scant 6% of American households to a mass market encompassing 44% of households. Assets under management have gone from less than $95 billion to more than $6 trillion. Six trillion. To put that in perspective, mutual funds today control a bigger chunk of America`s collective purse than banks. "It is no wonder that the industry has adopted the [ever-rising] mountain chart as its favorite graphic," said the CEO of OppenheimerFunds, Bridget Macaskill, who also spoke at the ICI conference.

The fund industry has had a powerful demographic wind at its back. Over the past two decades, baby-boomers grew up and got religion about saving for retirement. Mutual funds were there to capture the torrent of cash flowing into individual retirement accounts and later into 401(k)s. Retirement savings now account for one-third of fund assets. Still, the fundamental reason for the huge success of mutual funds was a simple promise: performance. Mutual funds let ordinary folks play Wall Street like a big shot. The sales pitch has always been about gaining access, hiring expertise, finding an edge.

You could turn over your money to a guy like Heebner, confident that his hard work, meticulous research, and peculiar genius would deliver consistently superior returns. A fund manager`s track record is public: If you could read a newspaper, you`d have no problem identifying the top managers. That`s a compelling story, absolutely--as long as some fund managers really did know what they were doing. We`re not absolutely sure of that anymore.

We have learned that past investment records make lousy crystal balls. With rare exceptions, the seemingly brilliant people of the past all blew up in the 1990s, which is exactly what efficient-market proponents like Eugene Fama of the University of Chicago and Burton Malkiel of Princeton predicted. These academics have long argued that no one can consistently beat the market, since the price of any stock reflects the sum of all opinion about that company. Sure, some funds will always be on top at any given moment, but that`s only because the market, in its inscrutable way, is temporarily smiling on that fund`s investment "style"--that is, its manager`s preference for small-cap growth stocks, say, or blue-chip value stocks.

Even when someone like Heebner beats the market for long stretches, he could just be lucky--the inevitable statistical outlier in a random distribution, like the one guy in 256 who flips heads eight times in a row.

That sort of talk exasperates Robert Sanborn, the once famous manager of the Oakmark Fund. Lately the mid-cap value stocks he favors have been hopelessly out of sync with a market besotted with large-cap growth stocks. But the market will change, sooner or later, as it always has. And so it`s only a matter of time, Sanborn is convinced, before active managers like him are vindicated. "The question I get is, `What are you going to do to get the performance up?` Well, I`m not going to `do` anything different. I`m not going to bend on my philosophy. I`m not going to buy overvalued stocks in hopes they become more overvalued." A principled attitude, perhaps, but costly. Redemptions have been "very steady and very heavy," Sanborn admits. "I had nine billion in assets, and now I have six." Venting his frustration in a recent letter to shareholders, Sanborn wrote, "Where is Dr. Kevorkian when you need him?"

So far the industry as a whole has escaped that kind of mass exodus, but anxiety is building. Despite all the money moving into stock and bond funds--$104 billion through July 1999 alone, even after subtracting redemptions, according to Financial Research Corp. (FRC) of Boston--the inflow is concentrated on just a handful of fund groups. FRC says that during the first seven months of 1999, six leading fund companies (Vanguard, Janus, Fidelity, PIMCO, Alliance, and MFS) captured 93% of the industry`s net inflows; that left crumbs for the other 648, nearly half of which were in net redemptions. "There`s no need to panic yet," says Jeffrey Shames, chairman of MFS. "But there`s going to be panic if we have a bear market. A lot of companies are going to fall off a cliff."

The mutual fund business has the classic symptom of a maturing industry: a dramatically slower rate of growth. Because of high redemptions, net sales have fallen 40% in a year. And there are a lot fewer new funds now: The number has fallen, according to Morningstar, from 558 in 1997 to 411 in 1998, and to 52 two-thirds of the way through 1999. Less growth means more competition. "If you want to grow your earnings, you`ve got to take market share from somebody else," says Shames. "We`re in a market-share war that will ultimately lead to dramatic consolidation." Actually, the consolidation has already begun. Such old-line fund groups as Founders, Mutual Series, Stein Roe, Scudder, Dreyfus, and Invesco have been absorbed by financial conglomerates.

Meanwhile, competition is beginning to erode the industry`s famously fat pretax margins (30% to 35% is normal even today). Large retirement-plan gatekeepers are ready to dump mutual funds with 1% to 2% annual management fees for dedicated "institutional" funds that cost much less.

The Schwab and Fidelity mutual fund supermarkets recently hiked the fees they charge the fund companies by 40%. One fund executive recounts nervously that even his financial printer proposed being paid a percentage of the fund groups` assets under management. (The fund company refused.)

Significantly, the one mutual fund product still very much in its salad days is the index fund, which is dominated by the Vanguard Group. Alone among major fund companies, Vanguard has embraced the efficient market hypothesis and offers a full line of index funds. Such funds have just one goal: to replicate (not beat) the performance of a particular market index, most often the S&P 500. Because the S&P has been so preternaturally hot in recent years, Vanguard`s 500 Index fund has been sucking up more new cash than any in the industry and is on a pace to unseat Magellan as the world`s single biggest retail fund, probably before the end of this year.

Vanguard`s total net sales of all its stock and bond funds during the first seven months of this year were an astonishing $36 billion, twice the total brought in by Fidelity over the same period. A thriving index business, however, is exactly what the industry doesn`t need. It`s hard to imagine a purer commodity than a fund that strives to produce the same gross return as its competition. Indexers have no way to compete except on price, which leaves scant room for the margins the industry has grown accustomed to. Vanguard`s 500 Index, for example, collects a diaphanous 0.18% a year from its shareholders, vs. 1.5% for the typical equity fund.

Consultant Avi Nachmany of Strategic Insight is deeply skeptical of the public`s newfound passion for indexing. "I`d guess that far fewer than half of the new index-fund customers buy for the right reason," he says. What`s going on, he thinks, is just another kind of old-fashioned performance chasing. Once the S&P settles back to earth, he predicts, mom-and-pop investors will be off in pursuit of the next hot thing, whatever it is. Quite possibly.

But Nachmany`s criticisms may not apply to the industry`s most important constituency, its sales force. About three-quarters of fund sales pass through intermediaries--brokers, financial planners, or the consultants who help corporations select fund menus for 401(k) plans. The latter two, in particular, tend to have serious doubts about active management, and their collective buying power has fed the shift into index funds.

Harold Evensky, a financial planner in Coral Gables, Fla., has become the de facto spokesman for the growing breed of so-called wealth managers who invest their clients` money in mutual funds. Of the $375 million Evensky and his associates oversee, nearly half resides in index funds, including 100% of his domestic large-cap stock allotment.

"As much as we would like to believe that a manager with good brains, energy, and talent can always beat the system," says Evensky, "we`re no longer persuaded--at least in the large-cap domestic market--that after you factor in trading costs and fees, anyone can do it consistently." So what do these nonbelievers want from active managers? Above all, "style purity"--that is, absolute loyalty to an investment pigeonhole, say, small-cap growth or mid-cap value. The predictability of such funds makes it easier for intermediaries to construct "efficient" portfolios of funds for their clients. Even fund managers faithful to their investing disciplines resent being told what to do by intermediaries. They say it breeds conformity, diminishes the scope of their craft, and penalizes creativity. Morningstar`s Rekenthaler, who has heard the fund managers` complaints, says, "They view planners as lightweights who weren`t good enough to go to Wharton or wherever the manager went, and who have a lot of gall trying to second-guess [them]."

To have a shot at being truly great, a fund manager probably does have to think differently from the crowd. Heebner, for his part, refuses even to take phone calls from planners and says he buys stocks he likes, period. "No one ever asked Peter Lynch about his investment style," he says testily. But customers--especially those who can divert oceans of retirement assets--ultimately seem likely to get what they want.

Says Morningstar`s founder Joe Mansueto: "You get the sense that Warren Buffett would be fired from Fidelity today for style drift." What emerges from all this is a picture of the fund industry very different from the one on display at the industry`s spring convention. Yes, there`s that $6 trillion behemoth. But institutional clients complain that the beast is dated and out of shape, and retail customers see it as a poor alternative to do-it-yourself investing online. They`re not impressed with the beast; they`re bored by it. The industry badly needs some giants of the stature of Lynch and Neff. The best this market has given it, however, are guys like Ryan Jacob, 29, the former manager of Kinetics Internet fund. Investing in nothing but Internet stocks (talk about style purity!), the fund rocketed more than 500% during one 18-month span. An impressive number, for sure, but it says more about mania than active management. (Jacob has now gone solo; we`ll see what develops.) For all their problems, mutual funds won`t disappear. Investing is hard work. It still takes some training and time. The amateurs flocking to online brokerages may imagine themselves masters of the universe, but that`s only because, un-like mutual fund managers, they aren`t confronted with their own audited results each quarter. When Avi Nachmany predicts it won`t be long before investors again want funds to make life easier, it`s hard to disagree. The big question is this: Will they want index funds or human managers? The industry is devoutly hoping for the latter. Like Sanborn, the active managers argue that their funds` recent underperformance is merely cyclical. "What people fail to realize," says Kevin Parke, chief equity officer of the MFS group, "is that this active investing vs. the indexing thing is a pendulum." Active managers held the upper hand for a couple of years in the early `90s and again, for that matter, in the second quarter of this year. Maybe after a few quarters of dazzling results, index investors will rush back into the arms of some genius managers. On the other hand, a lot has happened since the days when everyone took active management on faith. Believing in genius doesn`t feel smart anymore. We know now that when new stars rise, old ones fall; that brilliance flares and fades away; that sometimes people just get lucky. Even some in the industry (and not just at Vanguard) admit that the efficient-market hypothesis has done a better job of explaining how things work than any theory with stock-picking talent at its core. "Sometimes I`m not sure that [active management] isn`t a big hoax," admits a veteran fund consultant whose confidence has been badly shaken. "Maybe, just to support ourselves, we`ve kind of perpetuated [a myth], and now people are starting to figure it out." But old myths die hard. There was a telling moment at the ICI conference when Robert Pozen introduced the keynote speaker. "Based on his hugely successful experience as manager of the Magellan fund," Pozen said, and there, amplified to heroic proportions on giant screens that flanked the podium, was the most famous face in mutual funds--the familiar pink complexion, the slightly bulbous forehead, the trademark puff of white hair. The effect was somehow ghostly, and appropriately so. Peter Lynch retired eight years ago, and he`s not coming back. SLICING THE PIE, VERY UNEVELY So far this year, six mutual fund families have captured 93% of net new investments in stock and bond funds. That leaves 7% for 648 others. VANGUARD 35% JANUS 20% FIDELITY 17% PIMCO 7% ALLIANCE 7% MFS 7% OTHERS 7% FORTUNE CHART/SOURCE: FINANCIAL RESEARCH Efficient-market theorists have long argued that no manager can CONSISTENTLY BEAT THE MARKET. Right now, they`re looking like geniuses. Evensky has invested nearly half HIS CLIENTS` ASSETS IN INDEX FUNDS. One mutual fund observer says that actively managed funds are perceived as "a marketing scam for suckers." Sanborn invests in mid-cap value stocks. He says he won`t bend, even though ASSETS HAVE FALLEN 33%. "I`m not going to buy overvalued stocks in hopes they become more overvalued."

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