Benjamin Graham brings together defensive investors and investment funds in chapter nine of "The Intelligent Investor." He says the benefits of funds include the promotion of savings and investment, protecting individuals from costly mistakes and generating returns reasonably comparable with direct investments.
To get started, he addresses the distinction between two types of funds that comprise “investment funds”
- Open-end funds, or mutual funds, can be redeemed on demand by the holder, at net asset value.
- Closed-end funds cannot be redeemed on demand, and they have a relatively constant number of shares outstanding.
Beyond that, there are other classifications:
- By the content of their portfolios, including stock funds, bond funds and balanced funds.
- By objective, including income, capital growth and defensive positioning.
- By sales commissions, in which there are load funds that charge investors a sales fee when the funds are bought or sold, and no-load funds that charge no sales fees.
- Split funds, in which the securities are split into a preferred issue which receives ordinary income, and a second issue that collects capital gains (if any).
Given all the possible combinations, and choices even within categories, what is an intelligent investor to do? Graham has some thoughts.
Performance
Getting into specifics, Graham looks at the what was then a relatively new product: “performance funds.” He also refers to the “cult” of performance, thus giving us a broad hint of what’s to come. Specifically, he points to funds that reached for yield, got temporarily better returns, which attracted more inflows, and then found it was harder to get the same outperformance when investing larger sums.
He offers this warning:
“The foregoing account contains the implicit conclusion that there may be special risks involved in looking for superior performance by investment-fund managers. All financial experience up to now indicates that large funds, soundly managed, can produce at best only slightly better than average results over the years.”
Graham adds that these large funds, if not soundly managed, can produce spectacular, but mostly illusory, profits for a while, but then impose “calamitous” losses.
Open-end or closed-end
Next, he tackles the issue of closed-end funds versus open-end funds. Open-end, or mutual, funds give their holders the right to sell at the daily valuation and they make new shares available. This has allowed them to grow. Closed-end funds have a fixed capital structure and, consequently, have diminished in relative dollar importance.
In discussing open-end funds and companies, Graham frequently refers to salespeople, whom he considers to be little better than snake-oil promoters (and perhaps at that time they were). Today, our debate would be over load versus no-load funds, with no-load funds enjoying a big lead in popularity and returns; load funds continue to be sold by sales people, accounting for sales fees.
But the environment was different in 1973, and Graham had “clearly evident” rules for investors. Buy closed-end shares at a discount of 10% to 15% of asset value, rather than buying open-end shares at a premium of 9%. Doing this should give investors about one-fifth more for their money. Whether or not this remains true is a good question for 2018. However, it would likely be subsumed by the index fund versus active fund debate. As we saw in an earlier chapter, Graham seemed to favor the equivalent of index funds, as did his protégé, Warren Buffett (Trades, Portfolio), years later.
Balanced funds
Finally, Graham takes a quick look at balanced funds, i.e., those that combine a specific proportion of bonds and a specific proportion of stocks. Referring to the bonds in these funds, he suggests it would be “more logical” for typical investors to buy their bond investments directly, rather than through a mutual fund.
I find that a curious suggestion in that typical investors (who presumably have invested little time and effort in learning the ways of the markets) would be able to successfully buy bonds. Indeed, developing expertise in bonds would be no less difficult than gaining knowledge about stocks.
A balanced fund likely gets typical investors closer than anything else to the objectives Graham has developed in the first eight chapters of his book. It includes a built-in allocation strategy, as well as professional management, and since there are so many of these funds, there should be options that suit every type of investor.
With the profusion of exchange-traded funds in recent years, typical investors might even find combinations of index and balanced funds.
Other thoughts
In a 2012 article for GuruFocus, Geoff Gannon provided some background to Graham’s experience with investment funds:
“Ben Graham managed a hedge fund – not a mutual fund. While it is true that Graham-Newman was an open-ended fund, it traded at a premium to its net asset value. So, it effectively became a closed fund.”
John Maxfield, writing for The Motley Fool blog, says Graham was prescient about index investing:
“Recent research backs up the Graham's assertion that individual investors are better off settling for the more certain returns of the broader market rather than the uncertain, generally inferior returns achieved by attempting to beat it.”
Writing for the Index Fund Advisors, John Spence highlights this practical advice in chapter seven:
“Graham believes it's reasonable to look at a fund's past performance, but the longer the better and anything less than five years doesn't tell you squat. However, what the market has done as a whole must be taken into account. In a bull market, huge returns can be posted using unorthodox and unsound methods.”
In conclusion, Graham has provided an option for defensive investors and less ambitious enterprising investors: mutual funds. While his discussion is tailored to his times, investors of 2018 can take away several lessons.
- First, there is no such thing as just a mutual fund. They come in many forms and combinations of features; to Graham’s list of categories we can add even more, including index funds and ETFs.
- Second, stay away from growth funds because to get extra growth (alpha), fund managers may have to stretch. As a result, growth funds don’t always deliver as well as their managers might hope.
- Third, balanced funds seem to fit the needs of many defensive investors, with their pre-determined allocations of bonds and stocks.
Finally, I will weigh in against load funds, which can almost preordain underperformance. Choosing a front- or back-load fund means giving up a significant amount of your capital before or after you own it. Losing 5% (for example) to a front-load fund means it is unlikely you would achieve even average performance.
(This review is based on the 1973 revised edition of “The Intelligent Investor”; republished in 2003 with chapter-by-chapter commentary by Jason Zweig and a preface by Warren Buffett (Trades, Portfolio). For more articles in this series, go here.)
