No Value in “Value” Mutual Funds

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Richard Gong is a value investor and a Co-Founder of Vuru. He seeks to empower investors by giving them the necessary tools and information to invest successfully.

 

With investors exiting mutual funds en masse ($15.3Bn was withdrawn from U.S. stock mutual funds in September), we wanted to dig deeper. On the surface, the sudden retreat of investors can be explained through the growing pessimism of global macro-economic conditions. But, are they leaving perfectly good mutual funds?

 

Investors should demand good returns from mutual funds, otherwise it would be much cheaper and safer to opt for an ETF that tracks the broad market, a particular index or sector. Moreover, one would expect that a value-based mutual fund to deliver outstanding results given the value strategy’s ability to historically outperform the market. Surprisingly, this hasn’t been the case.

 

It’s important to note that the value investing philosophy isn’t flawed but it is the fund managers that have performed poorly. We’ve found that “value” mutual funds have simply chosen third-rate stocks, much like the rest of their peers.

 

A prominent structural deficiency of large mutual funds is that they end up bidding against themselves and buying positions for more than it should, thus pushing the price up. This can diminish returns as these funds will be forced to purchase increasingly pricey stocks.

 

For example, here are 2 “value” funds that have underperformed the Russel Midcap Value Index over the past 10 years and show lacklustre value picks. We took some of their top holdings – the stocks they have the most conviction in – and analyzed them in terms of their valuation through its discounted cash flow with a 15% discount rate and its historical fundamentals.

 

It’s safe to say that both funds’ performances as well as holdings are pretty underwhelming.

 

Fidelity Value Fund (FDVLX)

 

Fidelity Value Fund’s latest prospectus begins with Chairman Edward Johnson touting the benefits of long-term investing which can deliver significantly better returns than panicked sell-offs.

 

However, Fidelity Value Fund has failed to outperform the value index over 1, 5 and 10 year periods.

 

 

1Y 5Y 10Y
Fidelity Value Fund -5.71% -3.01% 5.91%
Russell Midcap Value Index -2.36% -2.36% 7.54%

 

 

They boast some undervalued stocks, such as MRVL and AES, but the fundamentals of the holdings are not impressive.

 

Although all of the stocks have consistent positive free cash flow and strong pricing power, they have struggled to maintain a satisfactory cash return on invested capital as well as return on shareholder’s equity. Moreover, 6 out of 7 have weak balance sheets (less than 0.5 total liabilities to total assets ratio).

 

 

Without a strict adherence to choosing quality companies that are undervalued, it is little surprise that this fund has failed to outperform the value index.

 

Vanguard Selected Value Fund (VASVX)

 

Within its latest annual report, Vanguard claimed that they were leaning “towards stable firms with strong fundamentals”. But, the Vanguard Value Fund has only beaten the Russell Midcap Value Index over 1 and 5 years and has failed to outperform the index over a 10 year period.

 

1Y 5Y 10Y
Vanguard Selected Value Fund -1.29% 0.10% 6.88%
Russell Midcap Value Index -2.36% -2.36% 7.54%

 

Currently, all of its top holdings are overvalued according to its growth price (DCF) and have a substantial capital expenditure ratio. Only 3 out of the 7 stocks show a satisfactory Vuru Grade – a score out of 100 based on a stock’s fundamentals and valuation.

 

 

 

Given Vanguard’s selected value fund outperformance over a 1 and 5 year period, should value investors buy these funds on a short term basis? We say no.

 

Investors tend to escape bad performing funds while buying into better performing ones, usually after the fund has already rebounded.

 

Moreover, its been clear that long-term returns are unlikely. Emory Assistance Professor, Klaas Baks suggests outperformance is only likely to appear after long time periods. However, in both cases, the mutual funds failed to outperform the Russell Midcap Value Index over a 10 year period.

 

Self-directed investors that are willing to put in a little research in their investment decisions, are far better off constructing their own value portfolio. A self-directed investor that chooses undervalued stocks (it’s easy, look at our DCF Whitepaper) with consistently strong fundamentals is historically likely to outperform the above-mentioned “value” mutual funds over the long term.

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