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Showing posts with label powerful lobbies and rising fees are diminishing the value of the humble mutual fund.. Show all posts
Showing posts with label powerful lobbies and rising fees are diminishing the value of the humble mutual fund.. Show all posts

Monday 19 November 2012

5 Things Mutual Fund Companies Won't Say

How runaway pay, powerful lobbies and rising fees are diminishing the value of the humble mutual fund.

1. "Cheap funds often outperform pricey ones."
If there's one thing people assume when shopping, it's that the more something costs, the better it is. It may not always be wise to shell out top dollar for that storm-cloud-silver Bentley convertible. But if you do, you can probably rest assured that you scored a nicer ride than your neighbor who bought a 10-year-old Corolla on Craigslist. But when it comes to mutual funds, cheaper -- not pricier -- usually means better. Sound counterintuitive? Think about it this way. Most investors regard the highest-quality funds as the ones that will eventually hand them back the biggest pot of money. Every extra dollar portfolio managers spend on items like researching stocks or hefty salaries for star analysts reduces that total.

Fund companies argue they can more than make up for any money they spend up front if they pick the right stocks. Indeed, some star funds, like the $5.7 billion Sequoia have managed to do just that. Although the fund is slightly more expensive than its peers -- customers pay $100 per $10,000 invested, compared with about $93 on average -- it's been worth it. An investor that chipped in that same $10,000 five years ago would have $12,457 today, compared with $10,436 for a fund that tracked the market.

Still, the trick for investors is picking a fund that will outperform over the next five years, not the past five. And many academic studies have shown that low cost rather than past performance is the best way to predict future returns. That makes the mutual fund business unique, according to experts like William Birdthistle, a law professor at the Illinois Institute of Technology. "It's the only industry where price correlates inversely to the quality of the product."

2. "We can't beat the market."
For baseball players, batting .300 has always been a magical goal. For pop stars, it's going platinum -- selling a million copies of an album. Mutual fund managers reach for a golden ring known as "beating the market." That means when Standard & Poor's 500-stock index is up 10%, they are up 11%. In some ways, that doesn't seem like such a lofty ambition. If not for the drag put on returns by investment costs, blind luck alone would guarantee that roughly half of funds would beat the market in any given year. But of course, those fees do make a difference, as do other expenses that investors don't pay directly, like brokerage commissions. In fact, over the past five years, only about one in three mutual funds beat its target, financial-data firm Morningstar reports.

Is picking funds a loser's game? It depends on whom you ask. Mutual fund companies and some independent analysts, including Morningstar, have long argued that smart investors can beat the odds. "It requires discipline," says Russel Kinnel, Morningstar's director of mutual fund research.

But many academics who've studied mutual fund returns, like the University of Maryland's Russ Wermers, say shopping around for market-beating mutual funds is typically a waste of time. When researchers like Wermers apply complex statistical models designed to remove the element of luck from the equation, the number of market-beating funds plunges almost to zero. "It's tough to find any asset managers that add value," he says.

3. "When skill fails, we just double (or quintuple) our odds."
Imagine a school with more teachers than students, or a restaurant with more chefs-de-cuisine than place settings. That's something akin to the situation in the mutual fund world. There are just under 5,000 stocks listed on major U.S. Exchanges. By contrast, there are more than 8,500 mutual funds and exchange-traded funds, by Morningstar's count.

Seem out of whack? One explanation, put forward by prominent academics John C. Coates and Glenn Hubbard in a well-known research paper paid for by the mutual fund industry, is that the vast number of funds is "consistent with strong competition" and that quirky as it may seem, it will inevitably lead to lower prices.

Others offer a more skeptical take. While small investors may not recognize how big a role luck plays in determining winners and losers, it's certainly no secret to industry insiders. Since individual funds are relatively cheap to launch and keep running, a bigger roster of funds boosts the odds that at any given moment, one or two will be handily beating the market. "If you have enough, some always look good," says independent consultant Geoff Bobroff.

4. "People aren't buying our product..."
While mutual funds that aim to beat the market remain by far the most popular variety, in the wake of the financial crisis they've been losing ground to cheaper alternatives that aim merely to match market benchmarks. Since 2008, investors yanked about $1 trillion from traditional active stock funds, while pouring $600 billion into benchmark-hugging index funds, including the wildly popular exchange-traded funds, according to researcher EPFR Global.

While the resulting savings has many consumer advocates applauding, others debate whether it's a permanent shift, or merely reflects a natural tendency for investors to temporarily distrust hotshot stock pickers during a bear market. One theory put forth by Bobroff, among others: With the market taking wild up and down swings based on macroeconomic news like the latest development in the European debt crisis or the Federal Reserve's decision to pump more money into the economy, it's gotten even tougher than usual for managers to earn their keep by sussing out slight differences between competing companies. But that could change if the market starts rising steadily again, the way it did in the 1980s and 1990s. "Active management isn't dead," Bobroff says. "It will come back."

5. "...except when we pay them kickbacks."
Benchmark-tracking index funds would perhaps be gaining even more ground on pricier stock-picking if not for an important but controversial advantage enjoyed by many active fund companies: cash they pay to intermediaries like big Wall Street brokerage houses that employ armies of financial advisers to peddle their funds. Although the payments have been made for years, critics describe the system in the bluntest terms. "It's basically kickbacks," says John Freeman, an emeritus professor of business and professional ethics at the University of South Carolina Law School.

The industry has long disputed the notion that the payments, which can be earmarked to cover record-keeping costs or for educational events like conferences, are in any way inappropriate or that they skew brokers' judgment.

In place of the K-word, fund executives use the term "revenue sharing." Both brokerage firms and mutual fund companies typically mention these agreements in disclosures they make available for investors that want to study them. One thing that the fine print typically won't say, however, is how much money is at stake. An exception is brokerage Edward Jones, which gives a detailed accounting of its revenue-sharing agreements with mutual funds as result of a recent regulatory settlement. In total, Edward Jones received more than $150 million from mutual fund and insurance firms in 2011. To put that in context, that amounts to about one third of the company's $480 million profit.

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