Expect Higher Sales of Stock Funds

Right Idea, Wrong Time?
In six weeks, the trailing five-year figures on investments will change dramatically.

Today's numbers support the nation's Great Investment Funk. Through August, the five-year performance of the big stock-fund categories looked like this:

Once October 2008 disappears off the trailing five-year period, however, the picture will greatly improve. While I can't provide the figures through Oct. 31, 2013 (that would be a neat trick, wouldn't it?), we can measure the first 58 months of the upcoming 60-month period. They have been kind to stock funds.

In contrast, those 58 months have been unkind to the alternative funds that have attracted so much media attention (although not yet, at this stage, fewer investor monies than the stories would indicate). The performance since November 2008 for the five largest categories of alternative mutual funds looks like this:

Barring a sudden market collapse, all standardized performance time periods for mutual fund advertisements will soon look strong: one year, five years, and 10 years. (The latter remains burdened with 2008 but no longer carries any trace of the 2000-02 bear market.) In other words, it will become much easier to sell stock funds. When the performance numbers are good across the board, they give the overwhelming visual impression of consistent success. Those are the asset classes that fund investors buy.

That strikes me as mixed news. On the one hand, investors could use probably use more stock funds (although recent market action has helped to boost their stock exposure.) Also, I am relatively bullish on long-term stock prospects. But I do admit to feeling a bit nervous about embracing stocks now--especially U.S. stocks. It's been a great run, but, I suspect, the stock market may need to catch its figurative breath. I worry that U.S. stock funds will once again be fashionable just as alternative funds finally become the better performers.

Seeing Things
One man who would surely see a pattern in stock-fund returns is John McEnroe. Johnny Mac is intelligent, articulate, and charming, as pleasant in the booth as he was unpleasant on the court. Unfortunately, he's also an incurable amateur psychologist. In this year's U.S. Open, a player would hit two shots into the net and McEnroe would immediately declare him to be either nervous, or overly relaxed, depending upon the score of the match. That player's mental state would then dominate the conversation, with McEnroe muttering darkly about how all would soon be lost. Ten minutes later, the player would win a game or two, and McEnroe would pronounce the crisis over and marvel at the athlete's mental toughness.

McEnroe's data analysis was like that demonstrated by the behavioral research exercise that asks students to evaluate the pattern of a coin flip. Each flip is recorded as "X" for heads and "O" for tails. The picture of the series is then given to suckers--er, I mean, MBA students taking a decision analysis class--who are asked whether the figures occur at random or if there is a pattern. Generally, they say the latter. They see a few clusters--which almost always occur with random tosses, as it would be quite unusual for an O to consistently follow an X--and talk themselves into perceiving something that doesn't exist. As did Mr. McEnroe.

Well, at least the man is smarter than the computer. The U.S. Open featured the dumbest "computer analysis" on record. An IBM computer crunched the results of the past eight years' major tennis tournaments and served up sheer uselessness. I learned that if one player won 19% of the points on his opponent's first serve, then per the computer's prediction he would win that set 37% of the time. (No joke, that is a verbatim example.) "Garbage in, garbage out" is perhaps too kind.

Every Little Bit
Slowly, surely, 401(k) fees are declining, particularly among the target-date funds that are now attracting most new investors' assets. Last month, PIMCO announced that it was cutting management fees by 20% on its RealRetirement target-date funds, from roughly 0.75% (the fees vary slightly by fund) to about 0.60%. That remains double where I think target-date fund management fees should ultimately land. Also, the funds carry additional administrative fees, plus in some cases 12b-1 fees when serving small and mid-sized companies. So there remains much room for improvement. The direction, however, is correct. Market pressure is doing its job.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.