The

 Intelligent  Investor  
Chapter  9:  Investing  in  Investment  Funds  
• Placing  money  in  the  shares  of  an  investment  company  is  a  viable  option  for  the  defensive  
investor  
• Mutual  funds,  or  open-­‐end  funds,  are  redeemable  on  demand  by  the  holder  at  net  asset  value  
• Many  of  these  funds  actively  sell  additional  shares  through  salesmen  
• Close-­‐end  funds  are  non-­‐redeemable  and  their  shares  outstanding  remain  relatively  
constant  
• Both  types  of  funds  are  required  to  register  with  the  Securities  Exchange  Commission    
• There  are  several  ways  to  classify  these  funds  
• The  division  of  their  portfolio    
§ If  one  third  is  in  bonds  and  the  balance  is  in  stocks  it  could  be  called  a  
balanced  fund  
§ All  stocks  would  be  called  a  stock-­‐fund  
• The  primary  objective  of  the  fund  
§ Income  funds  aspire  to  have  an  above  average  rate  of  dividend  yield  
§ Growth  funds  aim  for  higher  than  average  rates  of  price  appreciation  
§ Stability  funds  would  aim  to  preserve  principal    
• The  method  of  sale  
§ Load  funds  add  a  selling  charge  to  the  initial  amount  invested  in  the  fund  
§ No-­‐load  funds  make  no  such  charge,  but  take  an  annual  advisory  fee  
• The  designated  area  the  fund  invests  in  
§ Foreign  stocks  and  specific  industries  
• The  sales  price  of  closed-­‐end  funds  are  not  fixed  by  the  companies,  and  therefore  fluctuate  
on  the  open  market  like  ordinary  common  stocks  
• Major  questions  that  the  mutual  fund  investor  should  ask    
• Is  there  any  way  the  investor  can  assure  himself  of  better  than  average  results  by  
choosing  the  right  funds?  
• If  not,  how  can  he  avoid  choosing  funds  that  will  give  him  worse  than  average  
results?  
• Can  he  make  intelligent  choices  between  different  types  of  funds?  
• The  benefit  of  investment  funds  for  the  defensive  investor  is  that  it  shields  him  from  being  
tempted  to  speculate  
• The  performance  of  investment  funds  is  generally  slightly  worse  than  the  overall  market  
despite  the  fact  that  their  costs  are  higher  than  direct  purchases  
• There  are  funds  that  achieve  significantly  better  results  than  the  market,  but  finding  these  
individual  funds  is  difficult  
• When  searching  for  outstanding  fund  managers  the  investor  should  analyze  at  least  the  past  
five  years  performance    
• If  there  has  been  a  large  upward  movement  in  the  general  market  during  the  period  
being  studied  then  a  larger  data  sample  should  be  used  
• During  bull  markets  managers  can  outperform  the  market  by  taking  undue  
speculative  risks  and  get  away  with  it  in  the  short  term  
• This  excessive  risk  will  ultimately  lead  to  investment  losses  over  the  long  term  
• One  problem  with  investment  funds  is  that  when  they  achieve  excellent  results  they  attract  
large  sums  of  new  money  to  invest    
• With  larger  amounts  of  money  under  management  it  becomes  harder  for  managers  
to  replicate  past  performance  results  because  the  universe  of  potential  investments  
is  much  smaller  
• Many  times  this  causes  managers  to  take  on  undue  risk  in  a  quest  to  outperform  the  
market    
• Smaller  fund  size  is  an  advantage  when  trying  to  obtain  outstanding  investment  
results  
 • Large  funds  managed  soundly  can  only  hope  to  produce  at  best  slightly  better  than  
average  results  
• Because  open-­‐end  funds  have  salesmen  pitching  their  shares  they  tend  to  become  larger  in  
size  than  closed-­‐end  funds  with  a  fixed  amount  of  shares  
• Consequently  open-­‐end  funds  often  sell  at  a  premium  to  net  asset  value  while  close-­‐
end  shares  are  obtainable  at  a  discount  to  net  asset  value  
• The  intelligent  investor  should  focus  on  buying  closed-­‐end  funds  selling  at  a  10%  to  
15%  discount  to  net  asset  value  
• During  bull  markets  young  managers  without  bear  market  experience  begin  to  define  a  
sound  investment  strategy  as  anything  likely  to  rise  in  price  over  the  next  couple  of  months  
• Young,  bright  and  energetic  managers  have  promised  to  perform  miracles  with  
other  people’s  money  for  years  
• Wall  Street  has  a  penchant  for  forgetting  past  lessons  and  repeating  past  bull    
market  excesses  in  the  future  
• Commentary  on  Chapter  9  
• The  schoolteacher  asks  Billy  Bob:    “If  you  have  twelve  sheep  and  one  jumps  over  the  
fence,  how  many  sheep  do  you  have  left?”    Billy  Bob  answers,  “None.”    “Well,”  says  the  
teacher,  “you  sure  don’t  know  subtraction.”    “Maybe  not,”  Billy  Bob  replies,  “but  I  darn  
sure  know  my  sheep.”  –  an  old  Texas  joke  
• Mutual  funds  were  created  by  Edward  Leffler  in  1924  
• They  are  cheap,  convenient,  professionally  managed,  diversified  and  tightly  
regulated    
• They  have  benefited  the  individual  investor  because  they  are  affordable  to  everyone    
• Despite  their  many  positive  qualities  mutual  funds  are  not  perfect  
§ Many  funds  underperform  the  market,  overcharge  their  clients  fees  and  
have  erratic  performance  swings  
• It  is  human  nature  to  buy  funds  because  of  strong  recent  performance,  but  in  reality  
this  is  one  of  the  worst  things  an  individual  investor  can  do  
• Past  performance  of  mutual  funds  over  the  last  50  years  has  proved  several  facts  
§ The  average  fund  does  not  pick  stocks  well  enough  to  compensate  for  
research  and  trading  costs  
§ The  higher  a  fund’s  expenses  the  lower  its  returns  
§ The  more  frequently  a  fund  trades  the  less  it  earns  for  its  shareholders  
§ Funds  with  volatile  performance  are  likely  to  stay  that  way  in  the  future    
§ Funds  with  high  past  returns  are  unlikely  to  remain  winners  in  the  future  
• A  fund  can  offer  value  to  the  defensive  investor  even  if  it  does  not  beat  the  market  
by  providing  diversification  and  freeing  up  the  investor  to  focus  on  other  things  he  
would  rather  be  doing  
• Below  are  several  reasons  that  funds  with  strong  past  returns  are  unlikely  to  
replicate  those  returns  in  the  future  
§ When  a  fund  performs  well  managers  often  are  lured  away  by  rival  
companies  which  drains  the  fund  of  talent  
§ When  a  fund  performs  well  it  receives  large  inflows  of  new  money  which  
increases  the  size  of  the  fund  and  makes  it  more  difficult  to  achieve  above  
average  returns  
§ Trading  larger  blocks  of  stock  can  be  more  expensive  increasing  the  
operating  expenses  of  the  fund  
§ When  funds  grow  in  size  the  management  fees  become  extremely  lucrative  
to  the  managers    
• As  a  result  they  often  become  timid  in  fear  of  the  possibility  of  
losing  those  fees  
• Index  funds  which  own  all  of  the  stocks  in  the  market  all  of  the  time  aim  to  mimic  
the  return  of  the  overall  market  
 § Because  of  their  extremely  low  cost  structure  these  funds  will  beat  the  
majority  of  actively  managed  mutual  funds  
• If  an  investor  is  tempted  to  search  for  managers  who  will  produce  above  average  
investment  returns  he  should  focus  on  the  following  attributes  
§ Managers  should  be  among  the  largest  shareholders  in  their  fund  
§ Their  expenses  and  fees  should  be  very  low  
§ They  are  not  afraid  to  be  different  and  take  contrarian  positions  
§ They  shut  the  door  to  new  investors  in  order  to  stop  new  money  from  piling  
into  the  fund  at  the  top  of  the  market  
§ They  do  not  advertise  their  funds  heavily    
• A  fund’s  expenses  are  likely  to  be  more  consistent  than  their  returns  going  forward  
so  the  intelligent  investor  places  a  high  premium  on  making  sure  fees  are  
reasonable    
• The  following  are  reasonable  expense  ratios  for  various  types  of  funds  
§ Taxable  and  municipal  bonds  –  0.75%  
§ U.S.  equities  (large  and  mid-­‐sized  stocks)  –  1.0%  
§ High-­‐yield  bonds  –  1.0%  
§ U.S.  equities  (small  stocks)  –  1.25%  
§ Foreign  stocks  –  1.50%  
• The  intelligent  investor  also  closely  monitors  the  amount  of  risk  the  manager  is  
taking  on  in  order  to  achieve  his  returns  
§ The  investor  should  look  at  the  funds  worst  ever  quarter  and  decide  if  he  
can  stomach  that  large  of  a  loss    
§ If  the  answer  is  no  he  should  take  his  funds  elsewhere  
• The  following  are  reasons  why  an  investor  should  sell  out  of  an  existing  fund  that  he  
owns  
§ A  sharp  and  unexpected  change  in  strategy    
§ An  increase  in  expenses  
§ Large  and  frequent  tax  bills  generated  from  excessive  trading    
§ Suddenly  volatile  returns  from  a  formerly  conservative  fund  
• Picking  investment  funds  is  similar  to  marriage  in  the  sense  that  if  the  investor  is  
not  prepared  to  stick  around  during  the  bad  times  he  should  not  invest  in  the  first  
place