Lipper held a third quarter mutual fund review and outlook session last week, in which equity and fixed income mutual fund performance and the debate over actively managed versus index funds was on the agenda. Highlights of the report were domestic equity funds delivering a 4.65% return in spite of natural disasters and rising oil prices, growth beating value, mid-cap and small-cap funds beating large- and multi-cap, and international funds continuing their strong run.
Sector equity funds posted gains of 6.82% in the third quarter, while world equity funds rose 11.48%. Particularly strong performers were Latin American funds, up 29.3%, and Japanese funds, up 18.32%.
Tom Roseen, senior research analyst at Lipper of New York, noted that U.S. domestic equity funds' near 5% increase was the best quarter they have had in a long time. He said it was remarkable that both domestic and international equity funds posted such strong gains for the period in light of recent events in the world, including bombings in London, deadly hurricanes in the Southern parts of the U.S., and continued chaos in Iraq and Afghanistan. The markets were able to shrug these catastrophes off and actually use them to their advantage, he said.
"In spite of a great deal of bad news all over the place, investors shrugged off most of it in the third quarter, and the market seemed to want to go up," Roseen said.
As to whether domestic equity funds are likely to continue this pace into the fourth quarter, Roseen said that while it is historically a strong period for stocks, a decline in consumer spending, rising personal debt and volatile oil and gas prices would likely put a damper on the market. Thus, he predicted U.S. markets would be flat to down for the remainder of the year.
Looking abroad in the third quarter, the second best-performing world equity category behind Latin American funds was gold-oriented funds, which posted a 20.15% gain. Roseen attributed this to the depreciation of the U.S. dollar as a direct result of the high prices of oil and gas following Hurricanes Katrina and Rita.
As to whether international funds will continue this momentum into the fourth quarter, Roseen predicted Latin America will do well due to lower inflation, interest rate cuts, a strengthening currency and an improvement in GDP. For Asia, he said he sees more signs of domestic recovery. Specific nations he expects to do well through the rest of the year are Japan and Germany, where he pointed to a number of positive reforms.
Nonetheless, Roseen did express some concerns for international funds through the rest of the year, including "wild-card" types of events, inflation, unemployment, global recession and oil prices spiraling out of control.
Andrew Clark, senior research analyst at Lipper, discussed the performance of the Lipper Model Bond Portfolio, noting that it was volatile in the third quarter and will likely continue its unsteadiness through the remainder of the year. The portfolio is broken into three parts: 50% in corporate bond funds, 30% in world bond funds and 10% each in mortgage and treasury funds.
The model portfolio's overall return for the third quarter was 1.91% non risk-adjusted and negative 0.51% risk-adjusted. As for taxable bonds, they returned 0.22% non risk-adjusted and negative 1.78% risk-adjusted. Using classification averages, the model portfolio returned 0.91% non risk-adjusted and negative 0.66% risk-adjusted.
"We do not expect the rise in bond volatility to end any time soon, or for the U.S. dollar to do anything but remain volatile," Clark said. While he is not concerned about inflation, he said continued increases in the Fed funds rate will add to instability in the fixed income market. Nonetheless, Lipper hopes to keep the model portfolio stable in the face of continued volatility in long-term rates.
The fund's main risks are the political activities in Brazil, which could potentially damage Brazil's exporting of natural resources; emerging market funds; and the prices of commodities, Clark said.
"Emerging market debt is highly priced at this point, so I wouldn't recommend rushing into the sector," he said. He added that he is less enthusiastic about mortgage funds due to a flattening yield curve, which might even invert.
Don Cassidy, senior research analyst at Lipper, concluded the presentation by discussing whether active versus passive management delivers higher returns over the long run. "This is a debate that will never end and is highly dependent on how the figures are presented," he said. Many actively managed asset management firms use "casual" or expedient and self-serving composites to manipulate indexes to present impressive results, and they also slice time periods to their favor, he said.
Cassidy recommended that rather than compare all 12 styles of actively managed funds against the S&P 500, there are proper benchmarks for each style classification. For instance, large-cap value funds should be benchmarked against the Russell 1000 Value, large-cap core against the S&P 500 and large-cap growth against the Russell 1000 Growth. Multi-cap value's true benchmark is the Russell 1000 Value, and multi-cap core's benchmark is the Russell 3000, Cassidy said.
The difference in results is remarkable when pitting actively managed funds against the S&P 500 as opposed to their proper benchmark, Cassidy said. For instance, when comparing all actively managed funds against the S&P 500 between March 2000 and March 2003, 59% of them underperformed the index during that time. But when comparing them to their proper index, only 53% of them underperformed their proper benchmark, he said.
Between March 2003 and February 2004, the difference is even more pronounced, Cassidy noted. Compared to the S&P 500, 65% of actively managed funds outperformed the index, but against their true benchmarks, only 29% beat their true yardstick, he said.
Cassidy also warned that there is a systematic bias against growth and large-cap funds, and that comparisons do not take into account that actively managed funds carry higher management fees than index funds. Cassidy concluded that answers to this longstanding debate will keep changing, depending on who the data is geared toward. "It is important to try and figure out the bias of the source by comparing data from indexers to data from active managers," he suggested.
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