Saturday, October 01, 2011

Who You Gonna Believe?

It’s interesting to note that there are some quotes from years ago that are just as valid today as they were when originated. One such is from the 1933 movie Duck Soup that starred the zany Marx Brothers. Although sometimes attributed to Groucho, it was Chico who said, “Well, who you gonna believe, me or your own eyes?” Essentially, this is the question that the mutual fund industry has asked investors since its inception. It is also its marketing strategy.

Mutual fund marketers promote the dubious benefits of investing in managed mutual funds despite empirical evidence to the contrary. Why do I say “dubious benefits?” Almost 10 years ago, I wrote in this column, “Think about this: The collective investments of all stock market investors perform equal to the market averages. After all, the stock market average performance is the result of the total of all investors’ actions. However, there are expenses associated with the investing process, therefore, after deducting these costs from the overall average, the results attained by individual investors must be lower than the average itself.”

The article continued, “Here is what John Bogle of Vanguard has to say about the costs of mutual funds: ‘In the world of mutual funds, costs are extremely large. The annual expense ratio of the median equity fund is now 1.6 percent and rising. Transaction costs are difficult to quantify with precision, but at the high portfolio turnover rates of the past decade (80% plus), an estimate of 0.5 percent to 1.0 percent hardly seems excessive. ‘All in’ costs, then, can be conservatively estimated at upwards of 2.0 percent per year.’” (This is still true.)

I then pointed out: “As a result, in order to beat the market, an investor must first exceed the market’s performance by at least 2.0 percent. If you invest in managed mutual funds, what is the likelihood of achieving that goal? Consider that numerous studies have shown that over the long term, the average mutual fund manager under performs the market. Why then would you believe that you could do better than a professional who has a huge staff and almost infinite information sources, yet still generates poor results?”

Do the Math

The arithmetic is undeniable. In order to exceed the average, an investor’s performance must better the average by at least the amount of the costs incurred. One does not have to be a math genius to recognize the logic of the basic arithmetic. Despite that argument being obvious in its simplicity, over the years, investors continued to invest in managed mutual funds, an amount that recently reached some $13 trillion, The fund industry’s mantra, “Who do you believe, me or your own eyes?” has worked all too well––for the profits of the mutual fund companies.

If more proof is needed, every quarter, Standard & Poor issues what is known as the SPIVA Report (Standard & Poor's Indices vs. Active Funds), easily accessed via Google. That compares the performance of managed funds to that of their comparable index. The 2010 report lists 17 fund categories (Large Cap Growth, Mid Cap Value, etc.) and three time periods (1, 3, and 5 years), for a total of 51 ratings. The 2010 year-end report showed that on average, two thirds of funds underperformed the indices, and of the 51 ratings, in only four cases did managed funds beat the index by more than 50%. In fact, 76% of the ratings showed that the funds were at least 60% worse than the indices, and almost half the funds were 70% or more worse. Would you place a bet in a casino with odds like that?

In several articles I have mentioned Warren Buffett’s advice to the average investor who does not have the time or inclination to properly research stocks and stock funds. He has said and written: “Cheap index funds are the best way to invest in the stock market.” Another strong advocate of that admonition is David F. Swensen. I suspect you have never heard that name before, so why would you listen to his recommendation?

The $16 Billion Investor

David F. Swensen, adjunct professor at the Yale School of Management, has been that institution’s chief investment officer for 26 years. He manages Yale’s $16 billion endowment fund and has the highest long-term rate of return of any major educational endowment manager. On August 14 th of this year, he posted an article in The New York Times excoriating the mutual fund industry (click here for the entire article). In order to ensure that you’re not “gonna believe me instead of your own eyes,” what follows are direct quotes from the article.

“For decades, the mutual fund industry, which manages more than $13 trillion for 90 million Americans, has employed market volatility to produce profits for itself far more reliably than it has produced returns for its investors. Too often, investors believe that mutual funds provide a safe haven, placing a misguided trust in brokers, advisers, and fund managers. In fact, the industry has a history of delivering inferior results to investors, and its regulators do not provide effective oversight.”

He then explains, “The companies that manage for-profit mutual funds face a fundamental conflict between producing profits for their owners and generating superior returns for their investors. In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets — and invest poorly. For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors.”

The Morningstar Myth

He then mentions a subject you might have read about in this newspaper. “Mutual fund companies, retail brokers and financial advisers aggressively market funds awarded four stars and five stars by Morningstar, the Chicago-based arbiter of investment performance. But the rating system merely identifies funds that performed well in the past; it provides no help in finding future winners. Nevertheless, investors respond to industry come-ons and load up on the most “stellar” offerings.”

Later on he writes this: “Meanwhile, the mutual fund industry shouts through a megaphone, making campaign contributions to influence politicians and lobbying to avoid regulation. Without any offsetting pressure from the investing public, Wall Street crushes Main Street.

What should be done? First, individual investors should take control of their financial destinies, educate themselves, avoid sales pitches and invest in a well-diversified portfolio of low-cost index funds, like those offered by Vanguard, which operates on a not-for-profit basis. (Even Morningstar concludes, in a remarkably frank study, that low costs do a better job of predicting superior performance than do the firm’s own five-star ratings.) Such a strategy reduces the fees paid to the parasitic mutual fund industry, leaving more money in the hands of the investing public.” [For more details, see my blog article The Morningstar Dilemma.]

A Revolutionary Idea

But he goes even further when he presents a radical idea that the mutual fund industry would frantically fight: “The S.E.C. should think outside the box in policing the behavior of the mutual fund industry. What about a requirement that every mutual fund offering be accompanied by an index-fund alternative, with the burden of proof on the vendor to justify the sale of a high-cost product? Fund companies, brokers and advisers would have to list all fees associated with the fund offering, along with a description of the impact on expected returns. Over time, mutual fund purveyors would have to provide a head-to-head comparison of the recommended fund and the index fund alternative (including the impact of taxes), demonstrating as clearly as possible the long-term superiority of low-cost, tax-efficient index funds.” Wouldn’t that be a kick in the head? (Although Mr. Swensen does not mention Exchange Traded Funds in the article, since they are index funds, they are a suitable, and in some ways a more desirable substitute for traditional index funds.)

So, who are you gonna believe, the “me’s” of the mutual fund industry, or your own eyes as they view the concepts of David Swensen, not to mention, Warren Buffett, and of course John Bogle?


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