|What is the Magic Number?|
In major league baseball, every year as the regular season comes to a close, commentators and fans begin an annual ritual of counting down what is known as the magic number. It refers to the combined number of games that a team must win or a team behind it in the standings must lose in order to clinch a playoff birth. Each time the team wins a game or the team behind it in the standings loses a game, the magic number is reduced by one. When the magic number reaches zero, the playoff birth is clinched.
In the mutual fund business, there is a similar drama beginning to unfold. The prize in this case is the distinction of being the nation's largest mutual fund, an honor long held by Fidelity's Magellan fund. But unlike baseball where the leading team has the advantage, in this case it is the second place fund, the Vanguard Index Trust 500 Portfolio, that is building momentum and seems destined to overtake Magellan and claim the title.
The 500 Portfolio has been winning investors at a consistent rate, but Magellan has been losing investors and according to Alpha Equity Research has suffered net outflows for the last 16 consecutive months. 1 Each dollar that Fidelity investors withdraw from Magellan and each dollar that Vanguard investors place in the 500 Portfolio bring it that much closer to striking distance, and ultimately to the day when it will bypass Magellan and assume the title of the largest mutual fund."There is a crisis in the industry--not just at Fidelity--in that index funds are killing actively managed funds"
David O'Leary, Alpha Equity Research 2
|Why is it important?|
Like it or not (and there are a lot of people in the investment business who won't like it), if and when the 500 Portfolio passes Magellan, it will be a historic event for the mutual fund industry. The relevance of the event will be discussed and debated extensively by mutual fund experts, commentators, fund advisors, and major periodicals. In addition to being a big victory for The Vanguard Group, it will mark a symbolic victory for proponents of indexing and passive management. The event itself will intensify the spotlight on the debate over passive vs. active investment management. Proponents of passive investing will celebrate the event while active managers will likely try to downplay its significance.
The importance of the event is far more profound than its effect on Vanguard and Fidelity. The reality is that all active funds compete against index funds and the S&P 500 is the primary benchmark that most stock funds are measured against. Stock funds that don't outperform it are finding it harder and harder to market their services. In fact, Vanguard has been so successful with the 500 Portfolio and its other index funds that many mutual fund companies historically known for beating the market (Fidelity included) have introduced their own index funds in what seems to be a clear case of "if you can't beat em, join em."
Index funds are already the fastest growing sector of the mutual fund business and this will possibly accelerate that trend. From 1986 to 1996, the amount of money invested in index funds grew from $556 million to $65 Billion 3. And if anything, individual investors have been slow to embrace passive management. Institutional investors invest a far larger percentage of their assets passively. Gus Sauter (Manager of the 500 Portfolio) estimated the total funds already indexed to the S&P 500 at over $500 Billion 3. Based on that figure, the Vanguard fund represents less than 10% of the funds invested in the S&P 500 index.
In the end, hopefully all the discussions will help to educate the investing public. Many individual investors are simply uneducated and unaware of the arguments and empirical evidence supporting passive management. Institutional investors and academics have known for years (many for decades) that passive investing is extremely difficult to beat and that the majority of active investors will fail in their attempt to outperform the market. If nothing else, hopefully the event and the continued growth in index funds will intensify the pressure on mutual fund companies to reduce their expense ratios to better compete with index funds."If the S&P were an athlete they'd be testing it for steroids."
Burton Malkiel, A Random Walk Down Wall Street
|How we got to this point|
Magellan originally rose to prominence under the guidance of Peter Lynch. Lynch outperformed the S&P 500 by 13.5% per year from 1977 to 1990. Morris Smith took over from Lynch and also outperformed the S&P 500 (14.5% versus 12.1%) during his two year tenure. Smith was followed by Jeffrey Vinik who also outperformed (16.5% versus 15.8%) over his four year reign 4. However, Magellan dramatically underperformed during Vinik's final six months in large part due to an unfortunate bet on bonds. Vinik resigned to start his own money management firm and the fund is now headed by Robert Stansky, whose challenge is to live up to the fund's reputation of outperformance.
The Vanguard 500 Portfolio was originally introduced in 1976 but it wasn't until 1995 that it passed the $10 billion mark in assets. Since that time it has been on a non-stop growth spree and officially became the second largest mutual fund in January 1997 when it bypassed Capital Group's Investment Company of America 5. Since then it has grown by an additional $11 Billion.
The fortunes of the two funds changed drastically in the last year and a half. The 500 Portfolio has had a remarkable performance run, beating the vast majority of stock mutual funds, while Magellan has faltered and underperformed the S&P 500 for the one, three, and five year periods ended June 30, 1997. Since year end 1995, in the midst of a raging bull market, the 500 Portfolio has grown in assets by more than 150% while Magellan has struggled to grow by roughly 15%.
Success in the mutual fund business is determined primarily by performance and publicity. Unfortunately for Fidelity, Magellan has been suffering from both poor relative performance as well as a great deal of negative publicity in the past couple of years. In addition to the bond bet, Vinik drew negative publicity for praising Micron stock while selling it for the fund and Fidelity also suffered from a string of fund manager departures. 6 On the contrary, the 500 Portfolio and Vanguard are currently enjoying a period of unusually strong outperformance as well as a significant amount of positive publicity in support of Vanguard's focus on low cost index funds. These occurrences have resulted in the 500 Portfolio dramatically closing the distance between the two funds."I suspect some day the fund will be larger than Magellan, I don't know when really . . . But we're not going to be setting any balloons off in the air when it happens."
Gus Sauter (Manager of the 500 Portfolio) 7
|When will it happen?|
Each business day millions of dollars flow into accounts at Vanguard. The 500 Portfolio fund is methodically growing larger and more powerful. Financial Research Corp. estimated that in the first 6 months of 1997, the 500 Portfolio took in $4.49 billion. 8 The fund took in $8 billion in 1996 and is on a similar pace this year. On an average day the fund absorbs in the neighborhood of $30 million 9 and accounts for 5% or more of all money going into stock mutual funds on some days. The fund is simply outselling all other funds by a wide margin.
Magellan is still trying to recover from Vinik's ill-fated 1996 bet on bonds, his subsequent resignation, and the negative publicity that followed. In recent months, Magellan has been successful in improving its relative performance, publicity and in reducing outflows. According to David O'Leary, the fund actually had net inflows for the first 11 days of August prompting O'Leary to state "The Bleeding is over." 10 But it may be too little too late. The 500 Portfolio is growing so fast that there may be nothing that Fidelity can do to prevent the 500 Portfolio from outgrowing Magellan.
If the 500 Portfolio continues to attract investors at its current rate and if Magellan continues to have significant redemptions, this battle could conceivably be over by the end of 1998. A potentially more likely scenario is that it will happen around the beginning of the new millennium. Projecting an exact month (or year) would be pure speculation at this point because the exact date will depend on a number of factors.
The size differential between the funds in the future will be determined by (1) the relative performance of the funds and (2) sales and redemptions by investors. Inflows and outflows are significantly influenced by the funds performance and the stock market in general but its useful to separate the two to get a better picture of what is really happening.
The stock market's effect on the funds is not as simple as you might imagine. In a way, the funds are like two freight trains rolling down the tracks. A heavier train will pick up more speed going downhill but will lose acceleration quicker going uphill. Similarly, Magellan's lead should lengthen when the market goes up because it is larger and experiences larger dollar gains causing the gap to widen. However, when the market goes down, Magellan will have larger dollar losses causing the gap to shrink. As an example, if Magellan is $15 billion larger and both funds increase in value by 10%, Magellan's lead in assets will grow by $1.5 billion. If both funds drop 10%, Magellan's advantage will shrink by $1.5 billion.
Future sales and redemptions of the funds will be influenced by both relative performance and the stock market in general. If Magellan continues to underperform, outflows will probably continue, but if it begins to outperform the S&P 500, it would possibly result in significant inflows. If the 500 portfolio begins to underperform versus other mutual funds, it will likely slow the growth of the fund. A bear market might also rattle investors and cause them to slow purchases of stock funds. Its important to note, however, that many investors are automatically investing in the 500 Portfolio on a regular basis via retirement plans or through dollar-cost-averaging strategies and these investors are normally more consistent and less likely to change strategies in the short term.
Positive factors working for the 500 Portfolio
- Outperformed Magellan and a majority of funds over the past one, three, and five year periods ended 6/30/97.
- Will outperform a majority of funds in the future over the long run.
- Lower expense ratio than active funds.
- More tax efficient than active funds.
- Vanguard as a firm is outselling all other mutual fund firms and currently holds about two-thirds of all assets in index mutual funds. This is significant because investors are more likely to invest in funds within a fund family. On July 24, 1997 total assets topped $300 billion at The Vanguard Group, up from $55.8 billion at the end of 1990. 11
Negative factors working against Magellan
- Underperformed against S&P 500 over the last one, three, and five years periods.
- Charges a 3% load on new purchases.
- Several other funds at Fidelity have also underperformed and inflows at the firm have dropped dramatically in the past few years.
- Still recovering from negative publicity from Magellan's underperformance and manager defections.
Another problem that Magellan faces, is the perception that funds that grow too large can not outperform significantly. Whether this is accurate or not, many investors drop the larger funds from consideration opting instead for smaller funds that are considered more nimble. Index funds don't suffer from this perceived problem, since they simply buy all stocks either equally or in proportion to their market capitalization and incur minimal turnover."If both funds maintain their present rates of asset growth, Magellan and Index 500 will switch places at the top of the fund heap by April 1998."
Scott Burns in The Eternal Skin Flint from Worth (9/97)
|Is it a sure thing?|
No. It's not a sure thing. But its probably only a matter of time. The S&P 500 has been and continues to be the benchmark to beat and Vanguard's 500 portfolio is established as the best known index fund. Investors are increasingly accepting the argument that index funds will outperform the majority of mutual funds over the long-run. Its minimal expense ratio and important tax advantages will continue to draw investors to it. The following are some scenarios that could delay the event, but probably won't prevent it from happening indefinitely.
- A bear market begins and investors panic by halting investments and/or withdrawing funds from the 500 Portfolio. There have been some reports of index fund investors confusing the assurance that the fund will equal the markets performance with a guarantee that it will outperform other asset classes and cash. The danger is that these investors may not realize that the fund will decline in value when the market drops.
- The S&P 500 experiences a sustained period of underperformance versus smaller stocks and other mutual funds. Investors could react by slowing their purchases or even withdrawing money from the fund. Many people (including Vanguard staff) have expressed concern that some of the large inflows into index funds have come from investors chasing the indexes hot performance. The concern is that these investors will quickly exit the fund if performance begins to lag.
- Magellan has a period of outperformance that makes the fund more attractive to investors. Some people believe Magellan will effectively mirror the S&P 500 going forward 12 making this scenario less likely.
- Fidelity drops Magellan's 3% sales charge making it more attractive to investors.
- Other mutual fund companies become more successful in attracting investors to their own index funds. Vanguard doesn't have a monopoly on index funds and other mutual fund companies may be successful in taking a bigger percentage of investors funds going into index funds in the future. Fidelity and USAA for instance, both have S&P funds with expense ratios competitive with Vanguard's (Fidelity's second-biggest seller in May was their S&P 500 index fund 13). According to David Masters of Micropal Inc. at least 20 S&P 500 index funds have been launched in the last year. Charles Schwab is also having success selling its index funds.
- Spiders (S&P 500 depository receipts) may continue to gain in popularity and draw investors away from index mutual funds. Spiders (Symbol SPDR - AMEX) mimic the S&P 500 and can be bought and sold at any time during market hours. They are also very liquid and have low expense ratios. 14"You wonder why fund managers cant beat the S&P 500?
Because they're sheep, and sheep get slaughtered."
Gordon Gekko (Michael Douglas) in the movie Wall Street.
Last update 8/29/97. Copyright © 1997 Investor Home. All rights reserved. Disclaimer