John Spence

Back to Boot Camp: Ben Graham's Take on Mutual Funds

So we've got the whole Enron mess clogging up the headlines. John Bogle says things are so bad that the mutual fund industry, which controls a majority of stock in America's corporations, must break its traditional silence and actively speak out on corporate governance issues. For many fund investors, particularly younger ones whose only experience is limited to a continuous bull market, this is their first experience with the bear. Many of us are hooked on the outsized gains of the 1990s, and like true addicts in denial we refuse to accept bleak forecasts for equities. We need some grounding.

In that spirit, let's break out the robes, light the candles, take a seat before the altar and open what many consider the bible of investing: Benjamin Graham's The Intelligent Investor. Ben Graham (1894-1976) is largely considered the father of value investing and has influenced countless investors, including the legendary Warren Buffett. Although the book was first published in 1949, Graham's updated analysis of mutual funds is timeless.

Individual Stocks vs. Mutual Funds

Ah, the old debate. In Graham's view, mutual funds have provided a worthy service to individual investors because they have generally promoted the good habits of saving, investment, and diversification. Mutual funds allow everyday folks to participate in professional money management for a fee of 1.42% of assets per year, the average expense ratio of the 7,678 domestic stock funds in Morningstar's current database.

Graham ventures the guess that over ten year periods, mutual fund investors as a whole outperform those who invest directly in company stock. He notes that there are sales forces pushing both mutual funds and brokerage accounts, but he sees brokerage accounts as potentially more dangerous because there is increased temptation to speculate.

Identifying the Best Mutual Funds (in advance)

Everyone's looking for the mutual fund that will outperform its peers in the future. However, it's a simple fact that not everyone can find these funds because then no one would do any better than anyone else.

"What is the point, if 1 out of 30 investors can pinpoint the managers who beat the market by 2% per year, of having 30 out of 30 investors try to pick those managers?" wonders the aforementioned Bogle.

In Graham's view, mutual funds shouldn't be criticized for doing no better than the market as a whole because they dominate such a large percentage of company stock that what happens to the market necessarily happens to funds in aggregate. Still, we're addicted to finding that hot fund. So is it possible to identify "the most capable management without paying any special premium for it against the other funds?"

Graham believes it's reasonable to look at a fund's past performance, but the longer the better and anything less than five years doesn't tell you squat. However, what the market has done as a whole must be taken into account. In a bull market, huge returns can be posted using unorthodox and unsound methods.

"Such results in themselves may indicate only that the fund managers are taking undue speculative risks, and getting away with same for the time being," wrote Graham.

Also, it's a cold fact that it is more difficult to outperform as a fund's asset base grows. One explanation is that the fund begins to affect a stock's prices when it buys and sells, especially in illiquid securities. For many reasons, it's inherently risky to look for high-flying managers and invest in their funds, which brings us to the next point.

Graham on "Performance Funds"

At least once a generation, a class of young "geniuses" will step forward with a surefire way to beat the pants off the market. These characters are almost always interested in the short-term fluctuations of stock prices, and they have sophisticated computer models that they claim can predict the future. According to Graham, their real talent is in exploiting the speculative furor that sweeps over a smitten public.

The latest example is the spectacular rise and fall of Long Term Capital Management, which is chronicled in Roger Lowenstein's book When Genius Failed.

According to Graham, financial "miracles" are usually the result of manipulation, misleading corporate reporting (sounds familiar), shaky capitalization structures, and outright fraud. Certainly, an overheated financial environment only makes matters worse.

Graham believes that although new laws are enacted to curb speculation after a bubble, in reality it's impossible to fully extinguish the urge to speculate. Therefore, it's the investor's duty to know about the speculative manias of the past so they can be avoided in the future. A good place to start is Edward Chancellor's history of financial speculation, Devil Take the Hindmost.

"All financial experience up to now indicates that large funds, soundly managed, can produce at best only slightly better than average results over the years," wrote Graham. "If they are unsoundly managed they can produce spectacular, but largely illusory, profits for a while, followed inevitably by calamitous losses."