For 401k investors with mutual fund investments, one way to add some spice to a portfolio — without taking on too much risk — is to buy a large growth fund. As the name implies, it tries to find those companies with good prospects for earnings and revenues but are still fairly large.
These stocks can certainly post strong gains as seen with Apple Inc. (NASDAQ: AAPL) and Amazon.com (NASDAQ: AMZN). The problem is that the performance of a large growth fund can vary substantially.
Compare the Wells Fargo Advantage Large Cap Growth Fund (MUTF: STRFX) to the Fidelity Growth Discovery (MUTF: FDSVX) fund. The Wells Fargo Advantage sustained a -2% loss over the past ten years and a 17% gain in 2010. The Fidelity Growth fund, on the other hand, was up 2% over the past decade, with a 24% return in 2010. If you look at the top holdings, both funds look strikingly similar. They each have Apple as the #1 position and share investments in Google (NASDAQ: GOOG), ExxonMobil (NYSE: XOM) and Qualcomm (NASDAQ: QCOM).
True, there is a difference in the expense ratio — but it is a non-factor. So why the disparity? While the performance of a portfolio is highly impacted by the overall market and the investment style, the fact is that the portfolio manager is also critical. So when evaluating a large growth fund — or any one, for that matter — here are some factors to consider:
#1: Avoid the Closet Indexer
Over the years, index funds have attracted a huge amount of capital. Then again, investors will get the same returns for a small fee. This is a good strategy because a vast majority of portfolio managers underperform their benchmarks. An actively managed fund, on the other hand, tries to beat the indexes, which justifies the fee. But what if the portfolio manager is really mimicking an index? Well, this is a “closet indexer.”
A way to detect a closet indexer is to check the R-squared metric, which shows the percentage of a fund’s performance that is explained by the index. In the case of the Wells Fargo Advantage fund, its R-squared is 92% (the index is the S&P 500). The Fidelity Growth Discovery’s is 91%. These are fairly high but likely not to the level of a closet indexer, which would be 95% or over.
#2: Making the Big Calls
When investors were desperately liquidating their portfolios in late 2008, Warren Buffett saw some attractive values. He agreed to invest $5 billion in Goldman Sachs (NYSE: GS) even though the stock price was plunging. It was a gutsy investment but it certainly has paid off. It is often making a few well-time investments that separates the good portfolio manager from the greats. So when analyzing a large growth fund, it’s a good idea to see how he or she performed during critical time periods. In fact, the past decade has been rife with major market turns, such as with the corporate scandals of Enron, 9/11, the real estate bust and the financial crisis.
For example, in 2003 the S&P 500 fell 2=2.10%. During this time, the Wells Fargo Advantage fund was down =29.89% but the Fidelity Growth Discovery fund was off only =15.94%. But did these funds catch the recovery in the market in 2003, when the S&P posted a +28.68% return? The Wells Fargo Advantage fund was up +26.83% while the Fidelity Growth Discovery fund was up only +19.87%. And of course, let’s take a look at 2008. While the S&P 500 plunged -37%, the Wells Fargo Advantage fund was down -38.82% and the Fidelity Growth Discovery fund fell by a painful -46.72%. Then in the following year – as the S&P rebounded by +26.46% — the Wells Fargo Advantage fund was up +36.47% and the Fidelity Growth Discovery fund was up +29.33%.
Actually, both of these funds have shown decent performances when navigating extreme volatility. But it looks like the Wells Fargo Advantage fund has been better with its calls, especially when dealing with the downside.
#3: Know the Cycle
Stocks generally follow the business cycle. When inflation becomes a problem and the Fed tightens the money supply, the economy may fall into a recession and share prices plunge. As the economy rebounds, the manufacturing companies will likely surge. Then the economy will stabilize and more companies will ramp-up capital investment.
As earnings improve, investors will look for growth stocks. So assuming the global economy is in the growth mode — which appears to be the case — then it’s a good idea to look at those growth funds that have shown been strong when the economy is well into a recovery. This may actually favor the Fidelity Growth Discovery fund, which has a good track record for this environment. As you can see, evaluating and monitoring a fund takes time. But this is necessary in light of the divergences in returns and market volatility. So if an investor does not have the time for the research, then the better alternative is probably index fund.
