DWS Dreman High Return Equity Fund: All That Glitters Isn't Gold

David Dreman is a rarity in the mutual fund industry -- he's a fund manager who has actually beaten his benchmark over the long term. Since 1988, his DWS Dreman High Return Equity Fund has earned 8.3 percent annually, slightly outpacing the Russell 3000 Value Index's eight percent return. Despite that achievement, it was announced earlier this month that Dreman would be replaced as the fund's manager. His case illustrates why investment track records can be so misleading, and why anyone should think twice before choosing to invest in an actively managed mutual fund.

As is often the case, High Return Equity's record is largely attributable to the early part of its history, when the Fund's assets were small. From 1988 to 1996, when, with the exception of the final year, the Fund's assets were under $100 million, Dreman outperformed the Russell 3000 Value Index by 3.2 percent annually, earning 18.7 percent versus the Index's 15.5 percent return.

That end point is noteworthy, because in 1995 Dreman sold his management firm (which ran three other funds in addition to High Return Equity) to Kemper Financial Services for $35 million. Like any investor, Kemper wanted to earn a return on their investment, and growing the Fund's asset base was the obvious way to do so. High Return Equity Fund's impressive record made it an easy sell.

And sell they did. Entering 1995, High Return Equity Fund's assets were $35 million. By the end of 1996 the fund's assets, aided by Kemper's distribution efforts, had swelled to $731 million; by 1997, they were up to $3.2 billion -- a 91-fold increase in just two years.

Assets weren't the only thing that increased; the fund's expense ratio did as well. In 1994, High Return Equity Fund's expense ratio was 1.25 percent, which means that the fund's investors paid roughly $440,000 in management fees for the year.

Two years after Kemper acquired the fund, the expense ratio had risen to 1.69 percent. Applying that rate to the fund's then-$3.2 billion in assets, we find that the management fee had ballooned to more than $53 million, a 122-fold increase in just 24 months. In the ten-plus years since the sale, the fund's investors have paid estimated fees totaling $900 billion, a stark contrast to the estimated $15 billion in fees paid in the earlier period.

The figures above illustrate why investment management is such an attractive business to get into. In less than two years Kemper earned back their initial investment from this single fund, without even accounting for the three other funds they acquired.

High Return Equity's investors, however, had a somewhat different experience. Since 1997, the fund has earned an annual return of two percent, trailing the Russell 3000 Value Index's 3.4 percent return by 1.4 percentage points. The vast majority of the fund's investors, then, have found themselves in a fund that's trailed its benchmark for more than a decade, despite owning a rarity -- a fund with a long-term record of outperformance.

If you were one of the comparatively few investors who actually earned the fund's long-term returns, you beat enormously long odds in finding a winner. But at the same time, you've watched your fund sputter for over a decade. Investors who have stuck with Dreman, even through the throes of last year's meltdown, presumably did so in the hopes he would recapture his old magic. But now even that hope is gone.

Thus you can see the dilemma that investors in actively managed funds face. Yes, it's easy to sort through a list of mutual funds to find one with a stellar past record. But as High Return Equity Fund, and countless other funds before, have shown, the past has nothing to do with the future. Actively managed funds require constant vigilance, and are cause for constant second-guessing.

If your fund hits a rough patch, how long will you stick with it? What will you do if the manager's success attracts a crush of new assets, making his job more difficult? Even worse, what will you do if he decides to cash in and sell his firm to another management company, resulting in a larger asset base and higher expenses? And what if, as in Dreman's case, your star manager gets fired?

It's easy to say, in the abstract, that in light of any of the above you'd simply sell and find another outperforming fund to invest in. But consider the odds.

Let's be generous and assume that you invest in only one equity fund at a time. If you give your manager an average of five years before you decide to move on, that means that you'll own eight funds over a forty year period.

We'll also be generous and assume that the odds of choosing a winning manager each time are 50/50. (They're actually lower because of the costs they incur.) The likelihood of choosing eight winning managers over that span is just 0.4 percent -- or one out of 256.

Does that sound like a winning proposition?

Of course, these are the sorts of questions that the mutual fund industry doesn't want you to consider when you're choosing your investment. They'd rather you focus on the handful of managers who have been riding a recent hot streak. When their time is up and you're looking for a better alternative, rest assured that they'll be ready with another list of worthy suitors for your assets.

And doing so can seem like a game; a challenge worthy of your skills. And the industry would love to have you play for as long as you'd like, as long as you don't do the math, and don't mind dealing with management companies who are more concerned with the return on their own capital than what you earn on yours. If that's the case, you and the mutual fund industry will get along beautifully.