Adrienne Pauly

Janus Funds Decline Sparks Debate

Falling stars, whether celestial or financial, draw intense interest from observers who react variously to them. The recent disappointment of the Janus Funds after years of stellar performance has produced a strong response within the financial community and further fueled the debate between proponents of active portfolio management and those in favor of index investing.

In fairness to Janus, they are in part a victim of their own success. Others study Janus investments and then jump into the same stocks pushing prices and evaluations skyward, which obviously has its benefits for the trend-setter, but also carries the risk of increased volatility.

Gus Sauter of Vanguard Group commented on the phenomenon in an interview (watch for it as an upcoming feature-length article on this site).

"That works for a while," said Sauter. "It used to be called the Peter Lynch effect. He created such a big fund that by the time he was done buying a stock he himself had driven the price up. That kind of momentum can last for a period of time. But there are other periods of time when that kind of investing does very poorly. Janus has been riding a very strong wave here."

How the mighty have fallen. By mid-August the funds of Janus Capital, representing $307 billion in assets, were up on average just 1.6 percent and lagged 60 percent of comparable portfolios. This contrasts with a whopping 65 percent gain for Janus funds last year. Coupled with a recent massive inflow of cash into Janus, it represents a classic example of herd mentality chasing past performance.

Annual Rates of Return For the S&P 500 and Janus Growth Funds

Sources: Janus Distributors, Inc., Wiesenberger; 2000 returns YTD through 8/16/2000

Yet part of the current pain at Janus is self-inflicted: a strategy of investing in volatile technology stocks and taking large stakes in young untried companies has loaded the funds with hard-to-trade private placements. In market downturns, these stocks often perform poorly.

The wild popularity of the Janus funds forced the company to close seven of its 16 equity funds, as they had become unwieldy. Still, this year alone another $38.5 billion of new cash has poured into Janus retail funds designed for individual investors. Most industry observers do not expect these new funds to generate the impressive gains of earlier years.

Managers at index funds are spared the challenge of deciding where to place new funds. As John Mortimer, vice president and senior portfolio manager at Schwab's Fund of Funds Group, explains, "As a index fund manager, you really have no opinion on the marketplace. You're hired to track the index: that is your goal. If the market goes down 20 percent, your goal is to go down 20 percent."

Index or Managed Funds? Two Index Fund Managers Straddle Fence

As to whether index fund returns will continue to outperform managed funds, Mortimer says, "Historically money follows performance. Just like managed funds can underperform, so can index funds during other time periods. We recommend a combination of indexes and actives. Schwab's mantra is a 'core and explore' philosophy which recommends investor have some of their assets indexed and some in actively managed funds."

John Montgomery, portfolio manager at Bridgeway Fund, Inc., oversees six funds, two of which are index funds. He talks effusively of the advantages of index funds, then confesses his own money is in managed funds: "There are a lot of advantages to index funds-lower cost, and tax efficiencies especially. And beyond that there's the predictability relative to the market. And apart from market surprises, you don't get the added surprises of management turnover or radical changes of philosophy. Also, longer term the vast majority of actively manage funds underperform the market, which speaks pretty strongly for index funds."

The Question Is Which Index Funds

Although he advises anyone not professionally in the market to invest in index funds, Montgomery's own money is in Bridgeway managed funds because, he says, "It is much easier for me to pick a winning stock than to pick a winning mutual fund. All four of Bridgeway's actively managed funds have beat the market this past year." He expects the next two years will be very good for small cap stocks, "but for the industry as a whole I'd say the opposite is true. I don't think the next 10 years are good to be as good as the last 10. I don't think a 20 percent return on the market is at all realistic on a sustained basis. Most people didn't notice the small cap correction in 1998, but that market dropped a full 37.9 percent-it was the worst small cap correction since 1973. We're back home now.

"But today the price-earnings on the stocks in our large cap fund are twice those of our small stocks. I ask, which of these two index funds is the riskier fund now? Very small companies are far more volatile, but these large companies are wildly overvalued relative to the small ones. I think the large companies are now much more susceptible to an extended downturn. I expect to see some sizeable downturns in my lifetime, but I will be fully invested whatever happens."