Mutual fund trends: Index funds win again

By Stan Choe

AP Business Writer

NEW YORK (AP) -- The numbers tell the story. The latest update on mutual fund performance is likely to widen the gap between investors who prefer index funds and those who favor the guidance of a stock picker. That plus some other trends from around the mutual fund industry:

-- Stock Picker Struggles

Why try to beat the stock market? More mutual fund investors are saying it's not worth the extra cost. Instead, they're piling into funds that aim to match a stock index's performance.

Last month, the most popular mutual fund was Vanguard's Total Stock Market Index fund, which took in a net $2.3 billion, according to Morningstar. It tries to mimic a broad U.S. market index that includes everything from tiny stocks to giants like Apple, and it has an expense ratio of 0.17 percent. A fund's expense ratio shows how much of its assets are used to pay managers' salaries and other costs annually. Domestic stock funds have an average expense ratio of 1.26 percent.

Not only do funds that are run by stock pickers carry higher expenses, many also fail to beat their respective index. After looking at the performance of all large-cap stock mutual funds over the 12 months through June 30, S&P Dow Jones Indices says that three out of five, some 60 percent, failed to match the 20.6 percent return for the Standard & Poor's 500 index, including dividends.

The trend is even more pronounced for funds focused on small and medium-sized stocks. More than two-thirds of all mid-cap stock funds, 69 percent, fell short of the 25.2 percent return for the S&P 400 index, and 64 percent of all small-cap funds had a weaker performance than the 25.2 return for the S&P 600 index.

Those numbers are actually better than in recent years. Over the last five years, 79 percent of all large-cap stock funds, 82 percent of all mid-cap funds and 78 percent of all small-cap funds failed to match their respective index.

-- Fidelity Adds More Stock

The country's biggest provider of target-date retirement funds is changing how it puts those portfolios together and is bulking up on stocks.

Nearly one out of every three dollars invested in a target-date retirement fund was with Fidelity at the end of 2012 - $157.2 billion, according to Morningstar - so the changes that it makes affect many investors. Fidelity says that it made the changes after rethinking some of its assumptions about retirement investing, gleaned from watching the behavior of 401(k) savers.

Target-date retirement funds are meant to offer savers a simpler way to invest their nest eggs. Savers pick a fund based on the year that they hope to retire. When the date is far off, the funds invest heavily in stocks because account holders have time to ride out the dips. As the retirement date approaches, the funds shift to more bonds and cash, which are less risky than stocks.

Fidelity's target-date funds will keep about 90 percent of their assets in stocks until savers get to their late 40s, says Bruce Herring, group chief investment officer for Fidelity's Global Asset Allocation division. Currently, the funds may keep about 75 percent in stocks for that age group.

The money being put toward stocks will come partially from bonds, which offer low yields. Stocks have also historically recovered their losses within 20 years, even after the worst declines, Herring says. That means investors in their late 40s can handle the increased emphasis on stocks that Fidelity is making, since they have 20 years until they retire: Fidelity now assumes that workers will retire at age 67 rather than 65 after analyzing its participants' behavior.

Fidelity's moves bring its funds closer to the stock allocations of its two biggest rivals. Fidelity's 2020 fund will keep 61 percent of its assets in stocks, up from 53 percent, for example. Vanguard's 2020 fund holds about 62 percent in stocks, and T. Rowe Price's holds about 68 percent.

-- Healthy Returns

Worries about all the squabbles in Washington are weighing down stocks, and the health care industry is at the center of the debate. Republicans want to block funding for President Obama's overhaul of the industry, and the federal government faces a possible partial shutdown if the fighting continues.

But mutual funds that focus on health care stocks haven't been feeling too much pain. They've been the best performers this year, returning an average of 36.9 percent. That compares with a the 21 percent return for the S&P 500. The next-best performance among mutual fund categories is the 30.8 percent average return for small-cap growth stock funds.

Much of the jump stems from excitement about drugs the industry is developing. Celgene (CELG), Vertex Pharmaceuticals (VRTX) and Regeneron Pharmaceuticals (REGN) have all surged more than 75 percent this year.

To be sure, Wall Street strategists can't agree on whether more gains are to come. Analysts expect health care companies' earnings to continue to grow, but at a more modest pace than for other sectors. S&P Capital IQ has an "Overweight" rating on the health care sector, which means that it expects it to be one of the market's better-performing sectors. Deutsche Bank, meanwhile, has an "Equalweight" rating, and Goldman Sachs has it as "Underweight."

Published: Tue, Oct 1, 2013