News

Mutual Funds – The Real Story

11 Jun 2009
Written by: Graham Bibby

Mutual funds are deemed safe. They file prospectuses with the SEC. They have theoretical oversight by an independent board of directors. They are regulated in the fees they can charge and the strategies they may employ. They have soothing names such as Fidelity or Alliance or Evergreen, and invest for the “long-term.” For the unsophisticated investor, mutual funds remain the most popular vehicle for individual participation in the stock market. The image of the mutual fund industry, in other words, is safe, sound, and sober or it was until the tech meltdown or the recent market meltdown.

The industry has morphed into a financial supermarket offering investors a range of choices, or, flavors of the month. They market it as being your benefit, but is it?

In the U.S. thanks to the adoption of 401(k) plans combined with the late twentieth century bull market, the mutual fund industry grew by leaps and bounds during the past several decades. Assets under management have grown from $135 billion in 1980 to over $10 trillion today. That’s roughly seven times the size of the hedge fund industry.

Be aware of “buy and hold” strategies, a Fortune magazine article from August 2000 “10 Stocks to Last the Decade”. The list included a who’s who and what’s what of stocks that were hot at the time. Enron, Broadcom, Nortel, and Nokia Fortune said this, was a “buy and forget” portfolio readers could one day retire on. By year-end 2002, the 10 stocks had declined on average 80 percent.

In a capitalist society, it is all well and good that companies are run for the benefit of shareholders and nor necessarily for customers. Not surprisingly, an investor would have been better off investment in a mutual fund management company than in the typical mutual fund.

Given the dominance of mutual funds in our financial life, one would think that journalistic inquires are commonplace. In reality, there is a shortage of critical reporting of the industry in the financial press. Mutual fund companies, unlike hedge funds, remain influential advertisers in the financial press.

Compare the stodgy mutual fund industry with the hedge fund world I inhabit daily. In particular, I think it worth commenting on the different ways managers are paid in the two industries. Mutual fund managers are paid largely based on asset growth. The greater the assets managed by the fund, the higher the fees, the greater the profits. While hedge funds or absolute return managers manage to charge management fees as well, the overwhelming bulk of manager compensation is bases on performance; typically they receive 20 percent of gains. This structure would appear to create an asymmetry of rewards- managers clean up in positive years, and investors eat the losses in down years. But because hedge funds pay managers based on performance, and because managers typically can’t get paid until they recapture the losses from the previous years, it is difficult for a fund to recover from a double-digit percentage loss. While mistakes occur, this arrangement provides the hedge fund manager with a powerful incentive not to lose his or her investors’ capital.

When we manage investors’ portfolios, we typically charge a management and then have a minimum return. We must beat before we get performance fees. We are aligned with the client’s objectives protecting capital making profits.

But what of the mutual fund industry? A Professor Lowenstein demonstrates, there were countless funds at major mutual fund companies that squandered more than 70 percent of their investors’capital during the bear market earlier this decade, only to later trot out new funds with new strategies and new manes. As professor Lowenstein points out, thanks to the consultants, mutual fund managers are typically judged not on how they perform in absolute terms, but on how they do against their asset class, such as small-cap growth or large-cap value. For example if the market is down 50% and the fund is down 48%, it’s deemed to have done a good job.

Put another way, if any hedge fund had a single year like the three the mutual fund industry had in 2000, 2001, and 2002, it would be out of business.

There is profound conflict to interest built into the industry’s structure, one that grows out of the fact that the management companies are independently owned, separate from the funds themselves, and fund managers profit by maximizing the assets under management because their fees are based on assets, not performance. As a result, a fund family may have 100, even 300 different funds, to reach every niche in the market. And that’s how the preponderance of funds are marketed and how they measure themselves – not by whether they made or lost money for their investors, but how well they did compared to a narrow benchmark of similar funds, whether it be a small-cap blend, mid-cap value, or whatever. Given the intense focus on marketing, at the expense of patient, careful stewardship, a fund group’s distribution and promotional expenses can rival or exceed all the costs of managing the funds. And it works; several major fund complexes have $1 trillion or more under their wings.

One in every two households has entrusted their life savings to these funds, and the industry hasn’t protected their monies in down market. You, the investor, are expecting a prudent protector and guardian. You go to the funds because you realize you are not personally equipped to manage money and you’re counting on the funds for their expertise and care. Instead, the industry has treated you like a walk-in to a discount supermarket to whom they are peddling the latest brand of soap. They peddle all manner of poorly managed, ill-conceived, and unnecessary products, all the better to capture market share for themselves. it is not good for you, but it works wonders for the companies that manage the funds; they are raking in gigantic profits.

Mutual funds conceal a deep, abiding conflict of interest between the shareholders of a fund and its managers. There are huge economics of scale in this business, meaning that the cost to manage $10 million of assets in nowhere near 10 times the cost to manage $10 million. And for the $10 billion fund, proportionately even less… and so on. But what’s good for the managers is bad for investors, who inevitably suffer when funds become obese and inflexible.

Mutual funds had a choice. They could remain patient, prudent guardians of other people’s money, creating the handful of funds for which they had managers or they could go a very different route spewing out a range of products, all in an effort to build really great business for themselves.

The industry succumbed to the temptations; the fund’s unrelenting focus is always the same: to gather more assets, sometimes within existing funds, sometimes by creating new ones.

We harbor the conceit that while the fund sponsors are in it for the money, the people who are personally managing our money will do the best they can for us. Sorry, that’s not what is happening. That’s why I set up Richmond Asset Management in 1991 to provide a service that utilizes mutual funds and exchange traded funds to access any of world’s investment markets when they are rising and to exit when downtrends are identified. Our benchmark is the Morgan Stanley Index. Since we began auditing our switches and returns, we are up over 260% since 2002 whilst our benchmark has lost money!

Many funds only sell through intermediaries; sorry, they won’t deal directly with the likes of you, ones that offered the most dollars, plus marketing and support services – plus a golf trip or two.

The brokers have made it clear to the fund sponsors that each fund must adhere to its specific niche, such as large-cap growth, health care, or high tech, and then closely track a benchmark for that sector. A fund manager might think at some point that high tech is no longer a good place for investors’ money. In the late 1990s, for example, the T. Rowe Price Science and Technology fund had soared, doubling just in the one year 1999. Still the fund stayed fully invested in its narrow sector, holding only a trivial amount of cash. The fund families know that it is up t the broker or advisor to rebalance your portfolio. For the fund manager to have taken money off the high tech table would have been to commit the tracking error that is no-no, Sorry if you thought that the manager was pursuing your best interests, not some broker’s.

The insidious aspect of the high fees and expenses the funds are harvesting is that the money is being used to manipulate the advice you receive and the management of your investments.

Increasingly you are on our own. The good news is that we are living longer now. The not-so-good news is that two-thirds of all the corporate pension plans have been terminated or cut back. All told, they are delinquent on their funding by hundreds of billions of dollars. Last year we out performed all of the Hong Kong retirement schemes by limiting the downside.

Now is the time to use mutual funds and Exchange Traded Funds as a tool for your gain not to enrich the mutual fund shareholders. Use them to access global opportunities and leave when trades reverse.

Investment companies, including what we now call mutual funds, gained a foothold in the United States in the 1920s. As the stock market was rising, and rising again, people who had previously relied on banks as a place of for their savings turned toward the new investment companies as a convenient way to get into stocks.

In the late 1990s, there was a perfect storm, a rare coincidence of forces that created such turbulence in our financial markets that stock prices were distorted out of all relationship to their normal patterns. There were huge costs to the innocents caught in its grip.

In the late 1990s, the new economy stocks soared to levels out of all proportion to their underlying values, indeed to levels well beyond even the excesses of the 1920s. If the NASDAQ Composite index, for example, was correct at 1,200 in April 1997, it surely wasn’t correct at 5,000 in March 2000 and then correct again at 1,100 two years after that.

Fortune magazine had selected in an August 2000 article entitled “10 Stocks to Last the Decade”

Broadcom
Charles Schwab
Nortel Networks
Enron
Oracle
Genentech
Univision
Morgan Stanley
Viacom
Nokia

By year-end 2002, these 10 stocks had declined on average by 80 percent. Thai is, they had suffered a loss of $800 billion.

Don’t you think your savings, your retirement plans, your portfolios require a manager with a proven methodology that identifies up-trends at an early stage, runs momentum programs to ensure you are in the top performing area and then protects your capital when downtrends are identified. This is what we do.