With the advent of highly liquid exchange-traded funds (ETFs) I am hard-pressed to think of a single reason to tie up my money for some indeterminate period of time with a fund that advocates that I buy and hold, then proceeds to turn their portfolios over 100% in a year while getting conflict-of-interest sweetheart deals from brokers. I do not recommend being underneath one of these when they keel over.
When I use the term “mutual fund” I refer to its common usage meaning open-ended, non-exchange traded funds that pool your capital with others’ for some alleged benefits. The advantages traditionally touted by mutual funds include professional management, diversification and lower trading costs. The three disadvantages I would cite with mutual funds? Professional management, diversification and lower trading costs. Let’s look at each:
Professional management. Professional management does not necessarily mean better management – or even good management. It simply means full-time management – it means that's what the managers do all day whey they go to their offices. Some do well some of the time, some do horribly most of the time.
If I work in a foundry eight hours a day, I'm a professional steelworker, too, but it doesn’t necessarily make me a better steelworker than the guy who only works 4 hours a day. If I'm a professional artist eight hours a day, that doesn't make my art better than the person who throws their whole heart and soul into their art for only an hour a day.
Over time, “professional” mutual fund managers tend to mirror the results of the rest of the investing population: a few, and only a few, will outperform the benchmarks with something akin to consistency. Some regularly under-perform the averages year after painful year. Over time, it is a well-established fact that the great majority of mutual funds under-perform the market.
A new study from Standard & Poor's found that over the past 5 years of stellar bull and disappointing bear markets, 70% of large-cap fund managers failed to match the performance of the index. Of those who matched it, very few exceeded it. This in a market where the benchmark S&P 500 Index is off 23% from its highs of a year ago. Almost 3 out of every 4 funds are down even more!
Remember, too, that mutual funds, because they can throw so much business to a broker, are, along with the big pension funds, usually the biggest beneficiaries of hot new issues or sweetheart bond or preferred deals like those Warren Buffett got from Goldman Sachs. It doesn't speak well for their capabilities that most of them, even with this free boost to their performance unavailable to the individual, still under-perform the broad market averages.
And you are still in mutual funds for the brilliance of their management? No way. So maybe you’re paying for…
Diversification. The old gray mare ain’t what she used to be. You used to buy a mutual fund in order to diversify broadly across a number of companies in a number of different industries. There are two problems with this. First, to goose returns, fund managers gravitate to the hot industries no matter what their prospectus says. (This is often called “style drift.”) Like Italian traffic laws, what mutual funds say in their prospectus is too often “merely a suggestion.” For instance, few people realized that FIDELITY MAGELLAN, then the largest fund in the world, during the dot.bom fiasco had 53% of all its assets in hi-tech securities.
Second is the simple fact that you can get the same diversification from ETFs. And in ETFs there is no style drift. They buy the companies in the index you intended to get in and stay in, not whatever strikes some bored 30-year-old fund manager’s fancy that particular day.
If you want honest diversification with no hint of style drift, buy an ETF. That only leaves the red herring of “lower frictional trading costs.”
Lower trading costs. True as far as it goes. Generally speaking, funds, with block trades of 100,000 shares or more, are going to pay less per share than you will for your 100 or 500 share trade. There are two big "howevers,” however.
However #1, in this age of electronic brokerage, I pay as low as $7 per 5000 shares when I place orders over the Internet or via one of the low-load brokerage firms' proprietary systems. The mutual funds don't beat that price.
However #2, the mutual funds often don't get as good a deal as they could, instead taking, as a rebate, soft-dollar items. This means they pay a higher price for the trade but the broker gives them, say, a few dozen top-of-the-line notebook computers for research. All too often, the fund managers' kids end up being the ones doing "research" on these computers – on video games and music downloads. Once the soft-dollar items enter the mutual funds' offices, there is no accountability for them.
And don't forget that you pay management fees and expenses to the mutual fund firm so it can give bonuses and salaries and cars and nice offices to its denizens to ensure they do their best thinking for you. These “necessary expenses” can eat you alive. In the ten years ending 12/31/2008, our (non-mutual fund) Growth & Value Portfolio returned a Compound Annual Growth Rate (OTCPK:CAGR) of 12.29%. I feel comfortable telling new clients we shoot for 12% CAGR but they should only expect 10%. After commissions and fees.
If a fund has an average annual return of 10% (and we’ll even let them use “Average Annual Return,” the arithmetic measure common to the industry rather than the CAGR geometric mean we use and think they should) and expenses of 1.25% (1.4% is the average), after twenty years $10,000 will be worth $7888 less than if expenses were 0.5%. If expenses are 2.00%, the return will be $6919 less than it would be at 1.25%. Those corner offices and free notebook computers can eat you alive.
Other disadvantages / dirty little secrets the mutual funds don’t talk much about:
You are locked in to most mutual funds for some period of time. To the best of my knowledge, only Rydex, Potmac, and ProShares allow you to trade the very next day after you bought their funds. And some – very few – pension plans and 401k plans allow this flexibility, as well.
Most funds, claiming they don’t want “hot money,” forbid you from taking your money out before 30 days or 90 days or, in some cases, even longer. This is because they “need to know the funds will be there for proper investment decisions.” Proper, shmopper! They’re taking my money and day-trading with it, buying sub-prime crap because the guy at Goldman gave their kid a computer and now they owe him one, and I can’t have my money until they’ve played with it for 30 days?????
If you buy a load fund it’s worse – they’ll give you your money back, but only after taking their 5% cut. I give them $10,000, decide a week later when the market’s down 700 points, to take it back and they charge me $500 for losing me $1000!
If you buy no-loads through one of the low-load brokerage firms, there’s a “gotcha” there, too. There is an extra fee if you sell within 90 days of purchase. Take the worst 90 days in 2008 or 2009 – did you really want to maintain your position for a minimum of 90 days?
Therein lies one of the more subtle and not-discussed disadvantages of mutual funds. Since these guys exist to “beat their benchmark,” not to “make money when they can and step aside when they can’t,” they’re always invested. There are times to be 100% invested and times we should step aside and be only 10 or 20% invested. But mutual funds are afraid you’ll say, “I don’t pay you to be in cash.” But you do – or you should…
Now. Let’s say you agree with me and you’ve decided to take your money out of a mutual fund and transfer the cash to your brokerage account. Whoa. Now they really dig in their heels. Broker-to-broker TOAs (Transfers of Accounts) happen all the time. Nobody digs in their heels and pouts about losing a client because the next time they are acquiring a client, their bad behavior will be remembered.
Not so in the mutual fund business. When you sell your whatever fund and put it into cash, even some quality fund families like Nicholas, Janus and USAA have a final “gotcha.” Each account holder has an entirely new number affixed to the money market fund than was affixed to their previous fund. So when you look at your statement and note your “account number” and tell them to TOA it, they tell you there is no such account number! But that’s only because of this little game they play that changes the account number on you. Their solution is to snail-mail you a statement, which tells you the new account number, which you can then tell them so they can transfer your money to your preferred broker.
The Hartford takes all this a step further and no matter that you are the only Irving Pallindrome Rumpelstiltskin in America, you provide your Social Security number, your mother’s maiden name, and your left toenail for DNA testing, they will still demand a “wet signature” – an original request on their original form signed in ink. Anything to float your money a little longer, I guess.
For decades, there has been no alternative if you want diversification. But now there is. ETFs and index funds.
I prefer ETFs. Buy and hold index funds are based on the notion that market risk is always worth taking. I’m not a believer in that theory. I agree, the long-term trend of the market is biased to the upside. But we don’t live in the future, we live in the present. And if some emergency should force you to sell (or another opportunity, say, to buy your dream home at a great price this year) before a multi-year period has elapsed, you may well have bought at one of the market’s higher marks and sell at a lower mark.
The trendline may be biased to the upside – but the sine curves that define the real world of the market on its way to that higher point are not! You have the same problem with ETFs but, because they trade on the exchange just like any other stock, there is a psychological difference. You don’t feel like you’ve sold your brother into slavery in Egypt just because you think it’s time to go into cash for awhile.
So why are you still holding mutual funds?
Possibly because you have to. Poorly managed, not well diversified, overpriced funds are the only choice in many pension plans, 401ks, and employee IRA accounts. Why is that? The reason given is that the plan administrator wants to ensure your safety (gee, thanks, Big Brother – we’re such idiots we need you to make decisions for us) so they insist on the “professional management” and “diversification” that mutual funds bring. Another reason, closer to the truth, is that they can always claim they acted prudently by offloading the responsibility to the mutual funds if anything goes wrong. And there are those who might, less charitably, notice a spate of new laptops courtesy of the mutual fund companies…
It is not prudent but, rather, a violation of the Prudent Man principle to refuse to acknowledge that we now have instruments that provide equal diversification with lower expenses, no style drift and more liquidity.
Time for plan administrators to wake up and smell the coffee. Oops. Coffee beans were eaten earlier but no one thought to brew it until the 15th century. When your plan administrators catch up to that date, you might ask them to include some ETFs among your choices…
Full Disclosure: We own no index funds. We own a grand total of one mutual fund, Rydex Managed Futures Strategy (RYMFX.) We can sell it any time we like, buy it back and sell it again -- just like an ETF. This article is part of our "Wall Street's Fairy Tales" series -- we just felt this title was more appropriate.
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