Fund that matches broad market is good base for a portfolio, expert says

MUTUAL FUNDS Components of stock market return 1990s (Projected*) .. .. .. .. .. .. .. .. . ..Best.. .. Worst.. .. .. Most .. .. .. .. .. .. .. 1980s..Case.. .. Case.. .. .. Likely Beginning yield.. .. 5%.. ..3%.. .. .. 3%.. .. .. .. 3% Earnings growth rate..4%.. ..10%.. .. ..4%.. .. .. .. 9% Impact of change in.. 8%.. ..2%.. .. ..-2%.. .. .. ..-1% price-earnings ratio Total return.. .. .. 17%....15%.. .. ..5%.. .. .. .. 11% *Initial price-earnings ratio = 16x; terminal price-earnings ratios of 18x, 12x and 14x, respectively.

June 23, 1991|By WERNER RENBERG | WERNER RENBERG,1991, Werner RenbergThe Vanguard Group bHC ulB

If anyone had developed an infallible system for predicting top equity mutual funds, based only on their past performance, you can be sure it would have come to the attention of John C. Bogle.

Forty years ago, he got a job with Wellington Management Co. after impressing Chief Executive Officer Walter L. Morgan with a research paper, "The Economic Role of the Investment Company," that helped him to graduate from Princeton magna cum laude in economics. By 1967, he had become president of the fund company.

Since 1974, he has been CEO of the Vanguard Group, the fund management firm created when Wellington's management and

investment adviser functions were divided.

Continuing to study the behavior of the ever-expanding fund industry, as well as the work of outside analysts, Mr. Bogle isn't aware of any system to pick the winners strictly on past performance. He doubts anyone has perfected one -- or could.

He prefers funds with long-run results that virtually match the stock market's. And he offers pointers on how to seek funds that could provide above-average returns.

Looking only at past rates of total return won't assure you of the abilityto identify funds that will be the top performers in the next year or decade, Mr. Bogle said. To prove his point, he showed that funds ranking among the top 20 in any year during the 1980s ranked no better, on the average, than 107th in the following year. Of the top 20 funds of the 1970s, only two remained among the top 20 in the 1980s; one fell to 309th out of 309.

Nor can a more sophisticated approach, such as Forbes' "honor roll" screening process, assure investors of superior results, he added. To qualify, top long-term performers must have done well in both risingand falling markets and must have had continuity of management -- "an eminently sensible and fair system," Mr. Bogle said.

Investment of an equal sum in each fund every year since the "honor roll" was first published in 1973 would have produced an average annual return through 1990 of 12.2 percent, according to Mr. Bogle. Adjusted for load funds' sales charges, the average annual return to investors would have dropped to 10.4 percent, he said.

During the same period, the Standard & Poor's 500 Index had an average annual return of 12.2 percent. If you had been able to invest in a no-load fund linked to the index, as Vanguard's 500 fund has been since 1976, and if you had to deduct 0.2 percent for annual expenses, your return would have been 12 percent -- much higher than the honor roll's.

You would have been certain of essentially matching the market's return instead of taking a chance you'd fall short.

While Mr. Bogle's case for a low-cost, passively managed index fund may be self-serving, its logic is no less persuasive. An actively managed equity fund with average annual expenses of, say, 1.5 percent has to outperform the index by 1.3 percent just to match the average return of an index fund with 0.2 percent annual expenses. A load fund has to outperform the index by even more to provide you a comparable return.

Mr. Bogle said he would make a broad market index fund the core of a portfolio and, unless you're approaching retirement, take "significantly greater risks" with the rest to aim for above-market returns.

Riskier funds could be concentrated in market sectors expected to lead the rest, in a diverse list of companies whose earnings are expected to grow at above-average rates, or in small companies of which big things are expected.

There are no short cuts to finding an appropriate fund in a category whose investment objective matches yours. He urged careful study of fund literature and reference works such as Morningstar's Mutual Fund Values.

(Speaking at a Morningstar conference, he reserved judgment on whether MFV's "star" rating system

has enabled investors to boost returns since the system's debut in December 1986. "This thesis is not yet proven, one way or the other," he said.)

Among other things, Mr. Bogle would check the consistency of a fund's performance, the split of total return between income and capital, its risk level, dividend trend, portfolio asset allocation, price-earnings ratios, earnings growth rates, portfoliomanager tenure, expense ratios and sales charges.

Even if all of the data don't enable you to predict a fund's performance, knowing them will let you understand what you're buying, he said, adding: "That's the beginning of wisdom."

Looking ahead, he estimated that the stock market's average annual total return will be 11 percent in the 1990s. As the accompanying chartshows, that projection is based on the dividend yield with which the decade began and his estimates of the earnings growth rate and of a drop in the market's price-earnings ratio.

If he is right, the average return from stocks will be in line with the long-run trend, although below that of the 1980s.

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