Legg's Value Trust-relative fund superstar or absolute media hype?

Within the institutional investment community there is a long-running debate over the likelihood of active mutual fund managers outperforming a passive index over extended time periods. Depending on the time period selected, it is not uncommon to find studies claiming that anywhere from 50% to 85% or so of active managers fail to beat "the market."

Indeed, some very successful and now quite large investment firms have risen to fame by developing index mutual funds and exchange traded funds (ETFs) to track the broad markets. A closer look at the "active" vs. "passive" investment style argument will have to be saved for a future article.

Alternatively, let's focus, perhaps slightly prematurely, on a topic that will no doubt garner increasing amounts of press coverage as the year 2004 draws to a close: How will Bill Miller do this year?

One of the most closely followed indexes tracking the U.S. stock market is, of course, the Standard & Poor's (S&P) 500. The index is comprised of 500 of the largest U.S. companies as weighted by market capitalization. Market capitalization is simply the economic value of a company's shares on a given day, or the price per share times the number of shares outstanding. The S&P 500 is a basket of stocks that collectively make up more than 80% of the total U.S. stock market. The remaining 4,500 or so mid-cap and small-cap stocks make up the remaining 20% of the total U.S. stock market.

Legg Mason's Bill Miller is currently one of the most famous mutual fund managers. His unique claim to fame is that his fund, Value Trust, has consecutively beaten the S&P 500 index for at least the past 11 calendar years, according to data from Morningstar for 1993 through December 31, 2003. This is, admittedly, quite an accomplishment in relative terms. It places the fund in the top 1% of all U.S. stock funds over the prior ten-year period.

Let's take a closer look. The table compares Legg Mason Value Trust (LMVTX) against all U.S. stock funds having the distinction of beating the S&P 500 Index for a given time period ending Dec. 31, 2003. For example, from Jan. 1, 1999, to Dec. 31, 2003 (the most recent five-year period), more than 2,300 funds had average annual returns greater than the S&P 500 Index. Legg Mason Value ranked 1,433, placing it in the 62nd percentile (1% = best and 100% = worst).

There are several points to be made:
1. The long-term track record of the Legg Mason Fund has been excellent.

2. Although it carries the title of "value" fund, LMVTX is not a conservative fund. The fund has historically experienced about 20% higher volatility than the S&P 500 index per beta.

3. Beating the S&P 500 index has no absolute value to an investor who suffers three straight years of losses during the extended bear market period of Jan. 1, 2000, to Dec. 31, 2002.

4. While few, if any, fund managers can claim that they beat the S&P 500 index annually over a number of years, quite a number of managers absolutely have made more money for their investors over extended time periods than this fund.
The key is minimizing the downside by paying dividends while keeping costs low for investors.

With a trailing S&P 500 Index price to earnings (P/E) ratio of 20 that is one-third higher than historical averages, a dividend yield of 1.80%, an inflation forecast of 3.00% and real GDP growth around 3.00%, there is a strong case to expect modest, single-digit average stock returns over the next few years (or even decade), with many bumps along the way. If this view holds to be true, the hefty annual expenses of LMVTX at 1.70% will erode returns and make beating the S&P an uphill battle.

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