Biggest Mutual Fund Surprises of 2014

Surprises are reminders of the fallibility of market timers and financial media pundits who like to make short-term market and economic predictions. Highlighting the events we didn’t expect can make us better investors by dissolving the illusion of control with a healthy dose of humility.

best-of-2014-2015-185The mutual fund industry can be considered a proxy for the capital markets and macro-economic trends because what happens to mutual funds generally reflects the financial behaviors and collective sentiment of the herd.

For this reason, investors are wise to periodically look back at big surprises to check our forward investment strategies and to maintain our humility. And thus we will hopefully participate in the positive surprises and avoid the negative ones!

So, with that, and in no particular order, I give you the biggest mutual fund surprises of 2014.

Biggest Mutual Fund Surprises of 2014: The Dominance of Long-Term Bond Funds

Pimco fundsI’ve lost count of how many years analysts, economists and financial media pundits have been predicting the rise of interest rates and the fall of bond prices.

The general investing rule is to avoid longer maturities when interest rates are expected to rise. The longer the maturity, the deeper the price declines when interest goes up. That relationship is why long-term bond funds are said to be interest rate-sensitive: They can lose big in a rising interest rate environment but they also win big in falling rate environments.

To the surprise of many investors and prognosticators, the more interest rate-sensitive the bond fund, the bigger the payoff in 2014. I highlighted this in my November post, ZROZ: Why Is This Bond ETF Up 30% This Year? As of this writing, PIMCO 25+ Year Zero Coupon US Treasury (ZROZ) is up 40% in price for 2014. That performances compares to a 5.9% gain on the Barclays Aggregate Bond Index, and short-term bond funds are much lower than that.

I humbly submit my own mea culpa that I had forecast 2014 as the year the Fed would finally begin shutting off the QE money tap and push interest rates higher. Fortunately, I only shifted a portion of my firm’s assets under management to short-term bonds and kept a larger portion in intermediate-term and multi-sector bond funds.

Making big moves based upon short-term predictions, no matter how confident you may be in them, is pure foolishness. And investors that moved all of their fixed income allocation to short-term bond funds, for the purpose of avoiding or minimizing price declines, found themselves on the short end of the bond fund performance stick in 2014.

Biggest Mutual Fund Surprises of 2014: Bill Gross Quits Pimco, Goes to Janus

JanusThe big surprise wasn’t just the fact that Bill Gross resigned from Pacific Investment Management (commonly called Pimco), a company he co-founded more than 40 years ago, but that the bond king chose Janus Capital Group (JNS) as his new employer.

In a Janus Capital statement released shortly after his Pimco resignation, Gross said, “I chose Janus as my next home because of my long standing relationship with and respect for CEO Dick Weil and my desire to get back to spending the bulk of my day managing client assets.”

But the real reason for moving his office to Janus is not publicly known. Perhaps he wanted to go to a mutual fund shop where he could be the smartest man in the fixed-income room? Or was Janus a good fit because they are small enough to benefit by having a big name like Gross on board but still large enough to accommodate Gross’s desire to manage bond portfolios again and have the opportunity to end his career on a positive note?

A related surprise is the massive cash outflows leading up to the end with Pimco. Earlier in 2014, prior to his Pimco exit, I reported this in a story, Pimco’s Biggest Problem (Other Than Bill Gross):

As co-founder and chief investment officer of Pimco, Bill Gross is not likely to fire himself. However, shareholders of his Pimco Total Return (PTTRX) fund have said goodbye in the form of 13 consecutive months of outflows. The resignation of his co-CIO and heir apparent, Mohamed El-Erian, was another noteworthy exit that magnified and extended Pimco’s problems. Are the brighter days ahead for Gross and Pimco or might there be bigger problems ahead?

That was June, and the asset bleeding continued through his departure and beyond. Again, Bill Gross leaving Pimco was not an enormous surprise for industry insiders but anyone predicting this even as recently as a few years ago would have been laughed out of a room.

Biggest Mutual Fund Surprises of 2014: Index Funds Continue to Dominate Active Management

VanguardIf you’re not Warren Buffet, ignore active management and invest in index funds. Sure, that’s an exaggeration … but not by much. Active management continues to get beaten by major market indices, and the Oracle of Omaha himself sees the wisdom of passive management.

In fact, in Buffet’s annual letter to Berkshire Hathaway Inc (BRK.B) this year, he announced that he advises his beneficiaries to invest in index funds after he is gone. Here are two key quotes from the letter:

“My advice to the trustee couldn’t be more simple: Put 10% of the cash in short-term government bonds and 90% in a very low-cost S&P 500 index fund. (I suggest Vanguard’s.) I believe the trust’s long-term results from this policy will be superior to those attained by most investors — whether pension funds, institutions or individuals — who employ high-fee managers.

“Both individuals and institutions will constantly be urged to be active by those who profit from giving advice or effecting transactions. The resulting frictional costs can be huge and, for investors in aggregate, devoid of benefit. So ignore the chatter, keep your costs minimal, and invest in stocks as you would in a farm.”

Buffet’s support of index funds isn’t surprising. But the fact that he advises to sell shares of his own company stock and avoid Wall Street is quite shocking.

If you are die-hard Boglehead, seeing a headline that passive investing beats active management is not a surprise but rather an opportunity to say, “I told you so!” And the Buffet nod is also a nice gold star for Vanguard funds.

The numbers also support Buffet’s advice: Through December 22, the low-cost index fund standard, Vanguard 500 Index (VFINX), is beating more than 80% of all large-blend category stock funds for 2014.

Could 2015 be the year that actively-managed funds finally gain the advantage over passively-managed index funds? I wouldn’t bet on it.

As of this writing, Kent Thune did not hold a position in any of the aforementioned securities. Under no circumstances does this information represent a recommendation to buy or sell securities.

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