Stock Pickers Are No Longer the Stars

By GRAHAM BOWLEY and JULIE CRESWELL

IT’S an old Wall Street pitch: Trust us, we’re experts.

The notion that it takes a pro to pick stocks has made a lot of money for the United States mutual fund industry — $46.9 billion on stock funds alone last year.

Yet, on average, investors who bought and held many of those equity funds barely beat the broad stock market during the past decade. Many of them would have done better by owning low-cost index funds.

Yes, stock pickers like Bill Nygren of the Oakmark Fund, Christopher Davis of Davis Advisors and Bruce Berkowitz of the Fairholme Fund have bested the market year after year, with only occasional missteps. And, yes, the past 10 years were rough for pretty much everyone. The Standard & Poor’s 500-stock index returned just 1.4 percent, annualized, from Dec. 31, 2000, to Dec. 31, 2010.

But what that painful run exposed — again — is that many professional stock pickers aren’t great at picking stocks. Actively managed funds, meaning ones that actually select stocks, charge relatively high fees. Yet fewer than half of the active funds that invest in the most valuable American companies — that is, those with large market capitalizations — beat the market during the past decade. The average large-cap United States stock fund returned 1.73 percent, annualized, during that period, according to Morningstar.

That marquee-name funds often stumble isn’t news. But even some insiders now say that their industry has not delivered as expected. Millions of baby boomers now confront a yawning gap between when and how they thought they would retire and when and how they actually will retire.

“The industry stinks,” says Robert L. Rodriguez, the chief executive of First Pacific Advisors, whose FPA Capital fund declined 34 percent in 2008, but rebounded by 53 percent in 2009 and 24 percent last year.

Disillusioned investors are leaving some fund families that were once considered paragons of lifetime investing. Investors have withdrawn billions of dollars from domestic stock market mutual funds for four consecutive years. And they have shifted hundreds of billions of dollars out of actively managed stock funds, which last year charged fees averaging 97 cents for every $100 invested on an asset-weighted basis, and put more into index funds, which charged an average of just 16 cents per $100.

Index funds, of course, don’t try to beat the market. They basically are the market, as defined by a certain index, like the S.& P. 500 or some sector benchmark. These funds, which are known as passive, rather than active, investments, today account for 23 percent of the $6.3 trillion invested in stock mutual funds. That is up from 10.5 percent a decade ago, according to the Investment Company Institute, the fund industry trade group.

“People have been let down by their heroes.” said Don Phillips, president for fund research at Morningstar. “They don’t believe any more.” Yet even as people embrace index funds, many are also experimenting with riskier — but potentially more lucrative — active funds, he said.

CONSIDER Jerry Verseput, a former engineer at Intel who is now an independent financial adviser in Eldorado Hills, Calif. He had worried for years that many equity funds seemed to move in lock step. He was shocked when his own mutual fund investments plunged in 2007 and 2008, when the financial crisis struck. He figured that the pros would have seen the trouble coming and protected his nest egg. Wrong. So he took control by putting $500,000 of his personal fund investments into exchange-traded funds, a fast-growing breed of index funds that can be bought and sold like stocks.

As Mr. Verseput altered his own investing strategy, he also shifted the $22 million of investments that he manages for 70 clients, many of them Intel employees, to exchange-traded funds from active funds. “I was able to sleep better at night,” he said.

Despite its often lackluster performance, the mutual fund industry remains lucrative and powerful. It is the bedrock of many people’s retirement plans: individual retirement accounts or employer-sponsored defined-contribution plans provide nearly $4.5 trillion of the industry’s $12.1 trillion in assets under management.

And the industry’s reach may soon grow if lawmakers and regulators in several states facing shortfalls in public employee pension funds move into 401(k)-type retirement savings plans.

The industry has given investors a dizzying array of more than 7,600 mutual funds from which to choose. But by last July, about half of the investors who put money into United States equity funds over the preceding 10 years were sitting on losses of more than 20 percent, according to an analysis of market performance and investor flows by Trim Tabs, a research company.

Since last August, as the stock market has rallied, many funds have moved back into positive territory. That gain can be explained by dividend income from shares held in funds and has little to do with stock appreciation, Trim Tabs says.

The Investment Company Institute challenges Trim Tabs’ conclusions and aspects of the method behind its calculations, saying it makes assumptions that do not accurately reflect the behavior of the average investor.

The losses over the years, of course, are not all the funds’ fault. Investors are often their own worst enemies. Many people tend to jump in and out of funds at precisely the wrong moments.

But the industry has enabled this behavior by minting new funds to attract investor dollars.

Critics of the industry argue that many fund companies are more focused on gathering assets than on managing them. For funds, one incentive is clear: more assets mean more fees. Fund managers charge investors a percentage of the assets they have under management.

Critics point to the industry’s penchant for introducing funds that attract investors chasing red-hot markets — though often just before these markets turn down. In 2000, at the height of the dot-com boom, mutual fund companies created 84 funds focused on technology stocks. Subsequently, the tech bubble burst.

Throughout 2010, the mutual fund industry marketed bond funds and attracted about $251 billion into them. But that inflow occurred even as interest rates had already fallen close to zero and many economists were forecasting a decline in the bond market. In fact, prices have fallen since late last year.

Similarly last year, American investors plowed $57 billion into mutual funds investing in overseas equity markets. Since November, however, those markets have been volatile.

And after eight consecutive months of withdrawals from United States equity funds, investors jumped back in recently, adding about $21 billion in January and February. Of course, by then, the market had been rallying for months.

Investors’ moves out of active funds have had startling effects on the industry. Several once-dominant fund companies have lost billions of dollars in assets under management.

Putnam Investments, the fourth-largest mutual fund company in 2000, has lost nearly three-quarters of its assets, or about $200 billion, in the past decade, through weak market performance and investor withdrawals. Janus Capital, another firm that enjoyed a high profile a decade ago, has lost nearly half of its assets, or $100 billion.

Even the giant Fidelity Investments was unseated last year for the first time in two decades as the nation’s largest mutual fund family. It was surpassed by Vanguard, which is known for index funds and had $1.4 trillion in assets under management.

“People gave up on beating the market,” said Loren Fox, a senior analyst at Strategic Insight, a research and data company in New York. “Investors said to themselves, ‘It’s so hard to beat the S.& P. 500, so I am just going to own the S.& P. 500.’ ”

James Aber, a spokesman for Janus, said Janus learned valuable lessons in the bear market in the start of the past decade. “We believe we’ve become a better firm because of it,” he said. “We’ve enhanced our valuation discipline, implemented better risk controls, and we now have a larger and more experienced research team.”

Like Janus, Putnam grew quickly during the tech stock boom, roughly doubling in size between 1999 and 2000, according to Putnam’s chief executive, Robert L. Reynolds. When the collapse came, fund companies that were heavily invested in technology and telecommunications stocks were hit hard, he said.

Mr. Reynolds said investors haven’t abandoned actively managed funds. “Everything we see from clients says there’s still tremendous demand for actively managed funds, which give investors the ability to outperform the markets,” he said.

Brian Reid, the Investment Company Institute’s chief economist, said that while some money had left United States stock market mutual funds, outflows from August 2007 to December 2010 amounted to only 7 percent of total assets in them. That means 93 percent of assets remained.

Mr. Reid said that there was a growing preference among investors for index funds, but that this shift probably had more to do with low costs than with other funds’ poor performance.

He said that while index funds were cheaper than active funds, that fact overlooked extra charges passed on by financial advisers to clients for actively managing the mix of the various index funds in their portfolios.

“I don’t believe that most people today believe in true passive management,” he said. “They want active management, just active management of index funds. That is an important shift.”

Nevertheless, it is a steep fall from grace for the mutual fund industry, which was once the darling of investors and introduced many people to the markets and the idea of investing in stocks.

Although the first mutual funds were created in the mid-1920s, the industry heyday began in the 1970s with the introduction of I.R.A.’s and employer-sponsored 401(k) defined-contribution retirement plans. By 1980, about 4.6 million United States households invested in mutual funds; today, some 51 million households do, or nearly 44 percent of the country.

FOR much of the 1980s and 1990s, as the market boomed, so did investor flows into mutual funds. It was the era of the star stock picker, as Peter Lynch of Fidelity and Michael Price of the Mutual Series posted eye-popping returns and developed rock-star cult status among investors.

As the tech boom turbo-charged stocks in the mid-1990s, a new generation of aggressive stock celebrities and fund companies emerged, and investors flocked to them.

“ ‘Hot’ managers were treated like Hollywood stars and marketed in the same fashion,” said John C. Bogle, founder of the Vanguard Group, in a speech in January at the American Museum of Finance on Wall Street.

Mr. Bogle, long a critic of active fund management, used the speech to chide the industry. “As the inevitable reversion to the mean in fund performance came into play,” he said, “these stars proved more akin to comets.”