The Intelligent Investor_ The Definitive Book on Value Investing - Benjamin Graham [105]
Index funds have only one significant flaw: They are boring. You’ll never be able to go to a barbecue and brag about how you own the top-performing fund in the country. You’ll never be able to boast that you beat the market, because the job of an index fund is to match the market’s return, not to exceed it. Your index-fund manager is not likely to “roll the dice” and gamble that the next great industry will be teleportation, or scratch-’n’-sniff websites, or telepathic weight-loss clinics; the fund will always own every stock, not just one manager’s best guess at the next new thing. But, as the years pass, the cost advantage of indexing will keep accruing relentlessly. Hold an index fund for 20 years or more, adding new money every month, and you are all but certain to outper-forms the vast majority of professional and individual investors alike. Late in his life, Graham praised index funds as the best choice for individual investors, as does Warren Buffett.6
Tilting the Tables
When you add up all their handicaps, the wonder is not that so few funds beat the index, but that any do. And yet, some do. What qualities do they have in common?
Their managers are the biggest shareholders. The conflict of interest between what’s best for the fund’s managers and what’s best for its investors is mitigated when the managers are among the biggest owners of the fund’s shares. Some firms, like Longleaf Partners, even forbid their employees from owning anything but their own funds. At Longleaf and other firms like Davis and FPA, the managers own so much of the funds that they are likely to manage your money as if it were their own—lowering the odds that they will jack up fees, let the funds swell to gargantuan size, or whack you with a nasty tax bill. A fund’s proxy statement and Statement of Additional Information, both available from the Securities and Exchange Commission through the EDGAR database at www.sec.gov, disclose whether the managers own at least 1% of the fund’s shares.
They are cheap. One of the most common myths in the fund business is that “you get what you pay for”—that high returns are the best justification for higher fees. There are two problems with this argument. First, it isn’t true; decades of research have proven that funds with higher fees earn lower returns over time. Secondly, high returns are temporary, while high fees are nearly as permanent as granite. If you buy a fund for its hot returns, you may well end up with a handful of cold ashes—but your costs of owning the fund are almost certain not to decline when its returns do.
They dare to be different. When Peter Lynch ran Fidelity Magellan, he bought whatever seemed cheap to him—regardless of what other fund managers owned. In 1982, his biggest investment was Treasury bonds; right after that, he made Chrysler his top holding, even though most experts expected the automaker to go bankrupt; then, in 1986, Lynch put almost 20% of Fidelity Magellan in foreign stocks like Honda, Norsk Hydro, and Volvo. So, before you buy a U.S. stock fund, compare the holdings listed in its latest report against the roster of the S & P 500 index; if they look like Tweedledee and Tweedledum, shop for another fund.7
They shut the door. The best funds often close to new investors—permitting only their existing shareholders to buy more. That stops the feeding frenzy of new buyers who want to pile in at the top and protects the fund from the pains of asset elephantiasis. It’s also a signal that the fund managers are not putting their own wallets ahead of yours. But the closing should occur before—not after—the fund explodes in size. Some companies with an exemplary record of shutting their own gates are Longleaf, Numeric,