Securities indexes in the U.S. and in many countries around the world are on course to record their fifth consecutive year of positive gains in 2007. These gains come on the heels of the dreadful equity returns experienced during the dotcom bust from 2000 through 2002. You should try to enjoy gains while you can, keep in mind that bull markets do not last indefinitely. Therefore, if you are looking to add a mutual fund to your portfolio, it will be harder to find a manager with experience in a down market. (To learn more about bear markets and crashes, check out Digging Deeper Into Bull And Bear Markets and Stock Basics: The Bulls, The Bears And The Farm.)
The Shrinking Supply of Fund Managers
History shows that the most successful fund managers are those who perform well in down markets as well as in up markets, but although there are many fund managers with terrific three- and five-year performance records, many have insufficient experience during market corrections. In a report to shareholders in 2003, David J. Winters, CFA, the former Chief Investment Officer of Franklin Mutual Advisers, stated: "At Mutual Series, we believe that successful investing is as much about avoiding risk and containing losses, thereby protecting shareholder capital, as it is about achieving profits."
Unfortunately, not all funds have managers with real-world experience in how to do this. This is compounded by the fact that not all investment strategies experience bear-market performances at the same time or in the same magnitude. For example, funds investing in large U.S. companies experienced a major downturn from 2000 through 2002, the worst correction since the 1974 to 1975 period, which almost destroyed the mutual fund industry. (To learn more about fund managers, read Why Fund Managers Risk Too Much and Should You Follow Your Fund Manager?)
The Quest for a Large Cap Fund Manager
According to Morningstar, there were 5,579 domestic large cap mutual funds in 2007, some with excellent returns over the past three and five years. However, within this universe, only 1,356 of the funds have managers with experience going back as far as the beginning of the year 2000 – that cuts out almost 76% of the original universe of available funds. These 1,356 funds sound like a lot, but if you were to narrow the universe down to, say, no-load mutual funds with reasonable minimum investments that are available to the average investor, then the list would shrink down to about 150.
Small Cap Fund Managers are Even Harder to Find
To examine the small cap universe, we need to extend the time period back to 1998, which was the last period of poor relative performance for small cap stocks. According to Morningstar Research, there were 2,011 domestic small cap funds in 2007, some with superb performance records over the past three and five years, especially compared to large cap funds. However, within this universe, there are only 260 funds that have managers with experience that dates back to 1998 - eliminating 87% of this universe. Of course, if we were to refine the small cap universe to no-load mutual funds with reasonable minimum investments that are available to the average investor, the universe would shrink to about 40 funds, leaving you with very little choice.
The Search for a High-Yield Fund Manager
Some fixed-income categories have also experienced very good fortune over the past several years, making it increasingly difficult to find a manager with experience in choppy waters. For example, high-yield funds experienced a difficult period in 2002, when some of the telecommunications companies like WorldCom defaulted on their debt. In 2007, there are 575 high-yield funds, commonly referred to as junk bond funds, compared to only about 230 after narrowing the universe to managers that endured the 2002 debacle. Further, this universe is substantially reduced to about 15 when excluding load funds and other funds that most investors cannot purchase. (To read more high-yield funds, see Junk Bonds: Everything You Need to Know, Common Mistakes By Fixed-Income Investors and High Yield, Or Just High Risk?)
The Shortage Extends to International Funds
The shortage of managers extends to international mutual funds as well. International markets also last tumbled dramatically during the 2000 to 2002 period. Currently, there are 1,318 large cap diversified international funds versus 263 funds with a manager steering his or her ship since 2000. That reduces the list by about 80%! Further, if you were to narrow the criteria to include only no-load mutual funds that are generally available to the average investor, your list would shrink to only about 20 funds.
The significant reduction in international funds with managers who have experienced a bear market is partly related to the recent growth in the number of funds in international investment categories. International markets have soared over the past several years, which has led to fund companies launching more international funds. (Learn more about these funds in Broadening The Borders Of Your Portfolio and Why Country Funds Are So Risky.)
What are your other options?
Ideally, you would want to find and invest with a manager that has successfully guided his or her fund through downturns in the market. If this search yields no results to your liking, you have a few options:
- First, you could invest with a manager who has steered another fund at his or her current company through a down market. This might be a reasonable alternative if the fund company employs a team approach, thereby making portfolio managers more interchangeable.
- Second, you could invest with a manager with bear market experience at another firm. Be careful if you choose this option because fund managers do not always bring their resources with them to a new company. A different environment with a new research staff may result in a very different performance record.
- Finally, if you still cannot find a suitable fund, you could simply hire the manager with the best overall investment background.
Other Factors to Consider
Bear market experience is not the only factor to consider when investing in a mutual fund. You should of course evaluate how the manager performs in a strong market. Be careful here because sometimes unusually positive returns can indicate that the fund is much more aggressive than it peers and may not provide much downside protection. (To find your optimal risk range, check out Determining Risk And The Risk Pyramid and Personalizing Risk Tolerance.)
After you have evaluated performance, both good and bad, you should consider a portfolio manager's academic experience and other qualifications. Today, fund companies tend to be very selective when it comes to hiring portfolio managers. If many of the major fund companies value strong academic credentials, they should also be important to you. Besides, you do not necessarily have to pay more for a fund manager with a strong academic background.
Similarly, many fund companies often require that managers be CFA charterholders. The CFA program is very comprehensive and is generally considered to be the gold standard for investment professionals. Again, if mutual fund companies value the CFA designation, it makes sense that it should also be important to anyone who is searching for a fund to add to a portfolio.
Another factor you may want to consider before making a new investment is whether a portfolio manager invests in his or her own fund. This information, however, is not always easy to obtain, but sometimes can be found in a fund's statement of additional information. This is not an exact science, but it can be reassuring to know that your manager's interests are in line with yours.
Wrapping It Up
Finding a fund manager with experience in a bear market is likely to continue to be a challenge as long as a streak of good mutual fund returns continues. This is not to say that it is impossible to find a manager capable of weathering the next downturn, but that mutual fund investors will have to work harder to find experienced managers. There are other alternatives, but none as comforting as investing with a fund manager who has successfully managed a product in both good and bad times.