Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

Why (Equity) Mutual Funds are the Worst Investments During Bear Markets (Part 1)

While everyone else is writing about the credit card issuers and the latest other trivia that's already been covered well by professional journalists, in keeping with my style to deliver absolute value, I decided to blow the lid off of some secrets the mutual fund industry doesn't want you to know about. After all, I already detailed the problems with the credit card issuers in my 2006 book "America's Financial Apocalypse," so to me it's really stale old news; more drama than anything else. This is an article every investor should read.  Now, my bias aside, let's begin.

If you’re like most investors, you’ve probably stopped looking at your 401(k) statements and other investment accounts. The pain associated with watching your retirement savings evaporate for over a year has become too much for most to bear. But this highlights an important lesson. You need to understand your investments.
 
Simply having a fund that invests in companies you’re familiar with isn’t enough. Knowing the fees, turnover ratio, historical performance, risk-adjusted returns, and so forth isn’t enough either. When you invest in managed funds, closed-end funds, REITs, or oil trusts, you really need to dig deep. You not only have to understand the investments of each fund, but you also need to understand how the funds work.
 
Hopefully, after you read this article you’ll be prepared to act quickly when the next bear market strikes. Acting quickly in my opinion means you should shift to money market funds (i.e. cash), and in some cases bond funds. In other words, you should avoid equity-based mutual funds during bear markets because they generally get hammered more than the overall stock market. So let’s examine why this might be the case.
 
As you might appreciate, fund managers don’t care if a company is a great stock. This designation can be attained by an impressive short-term price performance. Since most mutual funds are not structured to take full advantage of short-term trading opportunities, they’re only concerned with identifying great companies. Great companies will become great stocks over the long-term, which is the time frame funds target. Keep in mind that money managers work in a very similar manner.
 
But the fact is that most mutual funds fail to beat the indexes. Why might this be? In short, the fees charged by mutual funds are disproportionate to the skills provided. This is a statement of fact, so you should never forget it. How can I make such a bold statement? Because I understand that the inherent limitations placed within mutual funds restricts the use of real investment management skills.
 
Rather than some great investment vehicle, most funds are simply glorified marketing machines that spend billions of dollars each year convincing you they have some special edge or understand the investment process in a way like no others. In most cases, all they really understand is dollar-cost averaging and diversification, but so does a sixth grader. Other times, the fund’s investment strategy is so generic it mirrors an index fund with much higher fees.
 
Quite simply, mutual funds practice very little risk management. Rarely do they even consider technical analysis. Rarely are they able to hedge declines using options and other risk management tools. Most important, mutual funds are unable to cash out when the market collapses because their securities positions are too large. Besides, they can’t charge huge fees if the assets are in cash, so they have an incentive to keep you in the market at all times.
 
As a result of these limitations, mutual funds are exposed to the biggest investment risk – market risk, or the risk that the market will decline. This risk is not possible to hedge through diversification. Mutual funds don’t want you to know this. And you can imagine why none of the so-called experts in the financial media bother to mention these facts. Here is a reminder. http://www.avaresearch...
 
As you will see, mutual funds have other features that place them at a great disadvantage during bear markets. To compensate for these shortfalls, they do have a few tools. The problem is that they’re inadequate.

Funds take a very long-term investment approach; with good reason. They have virtually limitless cash to invest; but only during bull markets. During bear markets, investors aren’t so crazy about handing their cash over, with good reason. When a fund manager likes a company’s fundamentals, he will buy more of the stock after declines, focusing on the long-term picture.
 
The problem with this is two-fold. First, investors are not aware that funds are making big bets that will impact short-term performance. And many investors do not have the investment horizons that funds do.
 
The second problem is the absence of risk management. Without a risk management system in place, fund managers are likely to buy shares of Enron and WorldCom all the way down to zero. This is precisely what they did. They did the same thing with the banks last year.  
 
Similar to mutual funds, money managers must remain at least 80 to 90 percent invested at all times due to their structure. As you can imagine, this can be very risky, especially during large market declines.
 
As well, because they can only charge for assets under management, money managers and mutual funds have an incentive to always remain invested in the market. This results in the perpetual bull-market mentality preached by these firms. As a result, mutual fund investors are unprotected against bear markets.
 
These characteristics of fund investment structure explain the lack of availability of risk management tools. Even if fund managers could liquidate a large portion of the portfolio’s holdings during or prior to a large market sell-off, most funds are so large they wouldn’t be able to dump enough shares of their largest holdings quickly enough without incurring significant losses.
 
Now let’s look at fund management more closely. Because mutual funds must remain nearly fully invested at all times, rather than practice risk management, fund managers buy more as the price declines. Therefore, the most important asset management tool of mutual fund managers is to lower the cost basis of each position. As you might imagine, this strategy is heavily dependent upon generating cash.
 
Fund managers have two ways to generate cash. They can sell more shares of the fund or they can rebalance the investment portfolio. They frequently use both methods in concert. Rebalancing basically involves selling shares of positions that have appreciated above the fund’s asset allocation model, and buying more shares of positions that have fallen below that dictated by the model. As a result, the rebalancing process yields very little net selling. Therefore, the primary manner by which mutual funds generate cash is by selling more shares of securities held by the fund.
 
Now imagine what happens during bear markets. Stocks get hammered. Eventually, some mutual fund investors sell shares of securities held by the fund. But they are mainly selling shares of stocks they expect to fall the most and use the proceeds to purchase what they feel are undervalued securities.
 
In other words, they are not doing much net selling during bear markets, so they are exposed to market risk. During bear markets, funds certainly don’t see a big influx of new cash from investors. So they won’t have much cash to lower the cost-basis of the most undervalued securities.
 
Finally, as investors sell their mutual funds, fund managers sometimes get stuck in a liquidity crisis, forcing them to sell positions at the bottom. The result is that during bear markets, mutual funds won’t have their biggest tool available; cash. As a consequence, mutual funds can decline by more than the stock market itself.  
 
I’ll explain these well-guarded secrets further in Part 2 of this article.
 
 
Disclosure: Author has NEVER owned a mutual fund other than as required in his 401(k) plan and currently does not own any mutual funds. However, the author does not guarantee that he will never own any funds because there are always exceptions.
 
 
Copyright © 2009. Mike Stathis. All Rights Reserved.
 
Restrictions Against Reproduction: No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without the prior written permission of the copyright owner and the Publisher. These articles and commentaries cannot be reposted or used in any publications for which there is any revenue generated directly or indirectly. These articles cannot be used to enhance the viewer appeal of any website, including any ad revenue on the website, other than those sites for which specific written permission has been granted. Any such violations are unlawful and violators will be prosecuted in accordance with these laws.
 
Requests to the Publisher for permission or further information should be sent to info@apexva.com