The End Game Of Mutual Funds

JEDDAH, 2 August 2004 — History is replete with examples of good ideas that have outlived their usefulness. For example, relatively recent invention as the typewriter has given way to the vastly superior word processing powers of the personal computer. Someday the keyboard and the personal computer will seem quaint. All of these inventions served their purpose well in their time, but they were all eventually relegated to the scrapheap of history in favor of better, more efficient forms of technology.
But technological development isn’t the only area where ideas outlive their usefulness. The principle of constant change holds true in most walks of life, and the investment arena is no exception. Remember what life was like trying to invest before the existence of mutual funds? What about those exorbitant commissions charged by brokers in the 1970s? How about not being able to look at your account online or make a trade instantly using the Internet? Yes, my friends, change is constant in the investment world too, and in my opinion, we are about to experience another big change with respect to what kind of investment vehicles we’ll be using.
Now I know what you might be thinking about now. How can an investment vehicle with over $30 trillion in assets, 300 million shareholders, and over 10,000 choices now be obsolete? Well, the answer is that while mutual funds are not quite dead yet, they are starting to become out of favor with investors, and for a number of very good reasons.
Scandals
A funny thing happened about 10 months ago. The public caught wind of the secret after-hours deals available only to favored mutual fund investors that cheated long-term shareholders out of profits. “The world changed on Sept. 3, 2003,” said Jay Baris, an attorney who works with the mutual fund industry in a recent Wall Street Journal article. He was speaking of the day New York Attorney General Eliot Spitzer unveiled his investigation into improper mutual fund share trading.
Since news of the fund scandal broke, investors have been questioning the trading practices of many of the most prominent mutual fund companies. They’ve seen many of their favorite fund companies come under attack and be fined and reprimanded by the SEC for improper trading practices. Until the scandal no one really realized that their personal net worth was being negatively impacted by the behind-the-scenes privileges of a few big players that the fund companies were eager to please at individual investor expense. The scandal got people to question what the fund companies were doing in their name. During this period of questioning people began to look at what they were getting for their money. Over the past five years, investors realized what they were getting wasn’t very much at all.
Underperformance
A great number of investors have come to realize that although their portfolios haven’t made a great deal of money over the past five or so years, the fees they have consistently paid for the privilege of that underperformance have been omnipresent. We’ll get to those outrageous fees in a moment, but let’s first stick with underperformance.
It is my contention that the mutual fund industry as a whole does a terrible job of managing money in a bear (down) market. One reason for this is obvious. The fund companies want you to buy and hold their funds, and therefore they won’t ever tell you to sell! Think about it, when was the last time you heard of a mutual fund company advocating the sale of one of their funds because the market was just not the place to be? I can’t recall ever hearing that. Now there may be a few talented brokers out there who will try to get you to rotate from one market sector to another given conditions in a specific market segment, but brokerages and fund companies don’t want you to sell. They want you to continue to blindly pump your dollars into their company so that they can grow their assets. Most of the time, growing your assets is not their first concern. And of course, the last thing they want is to lose your assets via a sale of one of their funds.
Worse yet, the fund companies are making money by charging high management fees despite bad performance results.
Think about that in your own profession, or any other profession. If a salesman were to fail to meet his goals over a five year period, would he still receive the same fees and commission than if he were to double his quotas? Not likely, unless of course he was a mutual fund.
Now, speaking of fees, that brings us back to just how much investors are paying for the privilege of that underperformance.
Fees
Now for the real killer, and what I think will ultimately bring about the obsolescence of mutual funds, high management fees. In the bull market of the late 1990s, people tended to pay only modest attention to the fees levied by mutual fund companies. After all, what difference did it make if you gained 20 percent in a fund and paid a 2 percent management fee? You were still ahead of the game by a whopping 18 percent. For a couple of years there, those kinds of returns were the norm. But as we’ve already mentioned, change is a constant.
What was once commonplace is no longer the norm, and so it is with double-digit mutual fund returns. Let’s face it, in a bull (up) market virtually anyone with a pulse can make money, and even average fund managers were able to do very well for a lot of shareholders.
So far in 2004 nearly all fund categories are down for the year. Of course, that hasn’t stopped fund companies from continuing to charge their management fees. According to Morningstar, the average actively managed mutual fund charges expenses of 1.56 percent. That fee is rain or shine, up or down market, win or lose at the end of the year. While this may not seem like much on its face, consider that when you purchase an average fund you are already in nearly a 2 percent hole that you have to then climb out of in order to be positive at the end of the year. With performance so far in 2004 largely in the red, that near 2 percent starting deficit could mean the difference between a profit and a loss.
The problem of high fees gets even greater if you are buying B-shares from a fund company or brokerage. B-shares are a class of mutual fund shares that charge investors a commission only when the shares are sold. Unsuspecting investors fall for this fee structure by being told that they can put all of their money to work right away, with no up front fees. What fund companies don’t tell you is that they then charge higher continuing fees to cover the cost of advancing the commission to the broker or agent that sold you the B-shares originally. Because of these higher fees, investors can end up earning far less money on their investments than they would have if they had just paid the management fee up front when they originally bought the fund.
It should be clear to you by now that I think investors have been taken advantage of by advisors advocating a buy-and-hold strategy, charging exorbitant management fees and delivering weak fund performance. All of this has helped make mutual funds yesterday’s investment of choice. So where should the smart investor go now?
I recommend to investors to move 75 percent of their portfolios into cash, and 25 percent to the oldest currency in the world: Gold, after all, gold has always been as good as cash.
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