Fund investors should loathe fees yet often flock to them. What could explain such paradoxical behavior?
One such paradox is found in The Legg Mason ClearBridge Aggressive Growth Fund (SAGCX) which costs investors 1.88% in fees yet has $5.0 billion in assets under management. Investors seeking large cap growth stock exposure should consider buying shares of a low cost exchange-traded fund like iShares S&P 500 Growth Index (NYSEARCA:IVW) or the Vanguard Growth ETF (NYSEARCA:VUG). These ETFs charge 0.12% and 0.18% in respective fees annually, which is less than one-tenths the fees of SAGCX. Alternatively, investors could buy shares of these liquid and readily available companies directly.
What do investors get for being charged 1.88% a year? They get nostalgia: the Legg Mason ClearBridge Aggressive Growth Fund outperformed its large cap growth benchmark in 1999 and 2000 by roughly 30% each year. This alpha would be impressive even for a hedge fund. Performance like that will earn a lifelong following of investors.
Yet this loyalty is sadly misplaced. The reality of mutual fund performance is that past success is not predictive of future success. Instead, mutual fund performance is mostly random and whatever observable performance persistence is seen among extreme losers, not winners. As a case in point, SAGCX has racked up mixed performance since those golden years at the turn of the millennium.
Since past performance does not guarantee future results, rational investors should ask, "What have you done for me lately?" SAGCX charges a 1.88% expense rate. It also saddles investors with overweight exposure to stocks with precarious financial stability:
Valeant Pharmaceuticals Intl.
L-3 Communications Holdings
TE Connectivity Ltd.
Tyco International Ltd.
These holdings do not score as "safe" according to the Altman Z-score: 13% of the portfolio scores as "distressed" and 14% of the portfolio lands in the indeterminate "grey zone." Do not panic, these firms are currently healthy. (Read the article disclaimer for further information.) However, firms which attain this scoring tend to underperform as a group and an abnormal amount see future financial distress.
Clearly, large cap growth investors should elect to buy IVW or VUG over SAGCX to avoid portfolio weakness and high expense ratios. Such a choice would reduce risk and avoid high fees, a terrible source of negative alpha.