Mutual Funds and Boca Brokers: Harmful to Your Wealth? – Part III

In May 1897, the great American humorist, novelist and social critic Samuel Clemens — best known by his pen name, Mark Twain — was in London. It was one of the stops on a round-the-world speaking tour he’d embarked on in 1895. He hoped to use the fees from speaking engagements to pay off the considerable debts he owed in the United States, due to a series of unsuccessful investments and publishing ventures. While Twain was in London, someone started a rumor that he was gravely ill. It was followed by a rumor that he had died.

According to a widely repeated legend, one major American newspaper actually printed his obituary and, when Twain was told about this by a reporter, he quipped:

“The reports of my death are greatly exaggerated.”

OK! OK! I’ll admit that the above headline calling for the death of actively managed mutual funds is also somewhat exaggerated, yet, if they are not already dead, they are certainly very sick puppies. In fact, according to an unusually large number of headlined articles in The Wall Street Journal, it would appear that an article in this column published in the August 2003 issue of Viewpointe was most prescient.

The article stated: “Despite its popularity with investors, the mutual fund industry is ripe for innovation and change. The miserable performance of the vast majority of actively managed funds has been recognized by the investor move to low cost index funds.” The article then went on to introduce the then new concept of Exchange Traded Funds. That was eleven and a half years ago.

It is curious that after many years of relative silence on the subject, only within the last few months has The Wall Street Journal issued a veritable barrage of articles on the superior value of index funds compared to actively managed mutual funds. This despite the fact that the newspaper relies on advertising revenue from the very same traditional mutual fund industry it is now undermining. Some of the information covered is mentioned in more than one article, but that really only emphasizes its importance.

Before we start on the headlines, I came across The Wall Street Journal guide titled “How to Buy a Mutual Fund.” It is possible that the editorial staff decided to take seriously what their own guide says: “Actively-managed funds are actively-managed by humans. The portfolio managers research the vast investment universe and then pick and purchase things that match their investment strategies. Usually, they’re trying to outperform certain indexes. For example, instead of trying to track the S&P 500 index, an active US stock fund manager tries to beat it. Investors pay these managers for their work. Then they cross their fingers and hope that the manager gets it right and beats the index. Often, however, the managers don’t. It’s hard to beat an index over many years.”

Below, listed chronologically, are the headlines, a short relevant comment, and quotes directly from each article.

WSJ––2/28/2014: Four Long Term Investing Tips From Warren Buffett

Every headline and following article run by the WSJ since that publication date (over the next ten months of the year) could have been avoided if investors took serious note of the #1 tip provided by Mr. Buffett, “Own low-cost S&P 500 Index Funds.” (You might recall the three-part Buffett article starting in the April 2014 issue of Viewpointe emphasizing that philosophy). Incidentally, on April 15 th, when that issue of Viewpointe was delivered, the price of Berkshire Hathaway’s “A” shares was $185,640. As of January 26 th, 2015 when this article was submitted, the price was $224,180, a 21% increase. The “B” shares’ increase was equivalent, from $125.77 to 149.70.

WSJ––8/21/2014: Investors Pile Into Vanguard, Eschewing Stock Pickers

“The surge is part of a sea change in the fund business in which investors are increasingly opting for products that track the market rather than relying on managers to pick winners.” The article then emphasized, “Vanguard got a huge boost this spring when Warren Buffett gave it (Vanguard’s S&P 500 Index Fund) a public stamp of approval in March.”

WSJ––8/24/2014: Active Stock Fund Managers Heading Way of Dodo Bird

“The underperformance of actively managed stock mutual funds doesn't bode well for their future, says Wall Street Journal columnist Jason Zweig.

‘Active fund management is outmoded, and a lot of stock pickers are going to have to find something else to do for a living,’ he writes, citing renowned money manager Charles Ellis, founder of investment adviser Greenwich associates and former chairman of Yale University's investment committee.” [That committee’s performance is the best in the business by far.] The article ends with this comment: “The debate about whether you should hire an active fund manager ... or a passive index fund . . . is over.”

WSJ––9/7/2014: Mutual Funds’ Five-Star Curse

Morningstar, at the request of The Wall Street Journal, produced a list of the top rated mutual funds from years ago––those with five-star ratings––and looked at them now. “The sobering fact: You’ll see many once proud five-star funds have dropped to four, three stars or worse. Analysts at the investment research company found the vast majority of the biggest five-star funds from five and ten years ago no longer have a top rating.”

WSJ––9/14/2014: The Rise of Ultracheap Financial Advisers

Herein is some really sound advice. “In a world in which the expected long-term return on stocks after taxes and inflation is 3% to 4% a year at best, financial advisers still typically charge 1% a year for their services. Why, when you take all the risk, does your adviser take up to one-third of the reward? It doesn't have to be that way, and the death knell for such high fees may already be ringing. Vanguard Group, which turned the fund industry upside-down and drove asset-management fees into the ground, is aiming to bring the same kind of disruptive change to the business of financial advice.

Vanguard manages $3 trillion in mutual funds and exchange-traded funds for a pittance of 0.19% in average annual expenses. The firm's Personal Advisor Services unit, which provides investment management and financial planning for a flat 0.3% annual fee for most clients, has $3.6 billion in assets, up from just $755 million at the end of 2013. Vanguard is joining a fast-growing trend toward delivering dirt-cheap financial advice online.”

WSJ––10/4/2014: The Market Makes a Case for Conservative Investing

“Most People Are Better Off Dollar-Cost Averaging in Index Funds.” That was the sub-headline that described the article’s judgment, but I have a personal story about that concept to tell here. About 55 years ago I made my first investment in a mutual fund issued by Neuberger and Berman called the Energy Fund. I knew nothing whatsoever about investing, or mutual funds, and even less about Dollar-Cost Averaging. However, a cousin who was an accountant recommended that action.

I began with a monthly investment of $50 from a salary of $5,000 a year (my wife was also working), and a few years later I upped the amount to $100 a month. This went on faithfully for some 20 years until the fund was closed. In my ignorance about investing at the time, I never looked to determine how the fund was doing. I estimate I put in between $15-18,000. I cashed out with $42,000. It would have worked even better if it was an index fund, but that category did not even exist at the time. The concept is still great for low salaried beginner investors.

WSJ––11/4/2014: ETF’s Are Climbing Toward $2 Trillion Mark

“Behind that big number are some historic shifts in investor behavior involving ETFs and their older and still much-larger cousins, mutual funds ($11.6 trillion in assets). For now, ETFs are benefiting from the steady shift by many stock investors away from actively managed mutual funds and into low-cost index funds.” The 2003 Viewpointe article referred to above was the first one in which I forecast the benefits and disruptive power of ETF’s.

WSJ––11/4/2014 Retreat From Fund Managers Accelerates

“The bad times are back for actively managed U.S.-stock mutual funds. Investors had been pulling huge and growing amounts of cash out of these funds each year for almost a decade, even as the U.S. market hit new highs. Yes, investors are still sinking money into U.S. stocks. But increasingly they are doing it through traditional index mutual funds and exchange-traded funds that track a specific market benchmark or sector, without the variability of a fund manager’s hand.”

WSJ––11/28/2014: As Indexes Soar, Active Stock Pickers Can’t Get Off the Ground

“Among all mutual funds that invest in big U.S. stocks like those in the S&P 500, only 9.3% are beating the index through Sept. 30. That means 2014 is likely to enter the record books as the year when active equity funds delivered their worst performance relative to the index, net of fees, since at least 1989. The decline seems even worse than it was three months ago, when I [the WSJ author] wrote that ‘active fund management is outmoded, and a lot of stock pickers are going to have to find something else to do for a living.’”

WSJ––12/26/2014: After a Bad Year For Funds, Prepare For A Big Tax Hit

“To the insult of chronic underperformance, mutual funds are adding the injury of unusually high taxes. The week of Dec. 15, dozens of mutual funds paid out taxable gains to their shareholders—even as the worst year of fund returns relative to market averages in modern history drew to a close. As of Dec. 19, more than 79% of U.S. stock funds had failed to beat their market benchmarks for the year. As if that weren’t bad enough, investors in many underperforming funds will find themselves owing whopping tax bills without having sold a share.”

WSJ––12/30/2014: A 2015 ‘Rebalancing’ Act for Investors

Burton G. Malkiel, the Nobel Laureate economist wrote: “Review what you are paying on any individual funds in your portfolio as well as the fees charged by your investment adviser. We are very likely to be in a low-return environment for some time to come, with a broadly diversified portfolio earning no more than 6% a year. If your total expenses are 2% a year, a substantial share of your investment return is consumed by fees. One way to control fees is to use index funds rather than actively managed investment funds. Every year we are told that the next year will be the one when active management will be rewarded. And every year we are disappointed. In 2014, well over three-quarters of actively managed stock and bond funds were outperformed by low-cost index funds.”

WSJ––1/4/2015 Investors Shun Stock Pickers

“Investors gave stock pickers a resounding vote of no confidence in 2014, pouring $216 billion—a record inflow for any mutual-fund firm—into Vanguard Group, the biggest provider of index-tracking products, according to preliminary figures from the mutual-fund group.

Those large inflows accentuate a trend away from fund managers and toward so-called passive investments that mimic indexes and other benchmarks for a fraction of the cost of the typical mutual fund. Active investments have been hurt by years of subpar performance and high fees.”

WSJ––1/4/2015: Will Funds Outperform in 2015?

“As every year, the vast majority of stock-picking mutual fund managers failed to keep pace with portfolios designed simply to track the broad markets. That’s a trend many expect to continue. Lawrence Glazer, managing partner at Mayflower Advisors in Boston, says 2014 showed the benefits having a core portfolio built around simple low-cost, broadly diversified stock and bond index funds.”

WSJ––1/15/2015: Behind a Bad Year For Active Managers

“Only about 13 of actively managed, large company stock funds posted returns above that of the S&P 500 for 2014, according to Morningstar. The S&P 5000 gained 13.7% for the year including dividends, while the average actively managed stock fund gained 10.2%. That kind of performance has had investors pouring money into index funds, especially exchange+ traded funds.”

If your stockbroker continues to promote actively managed mutual funds, ask him to explain this salvo of headlines from a newspaper he must subscribe to.

Now, if you don’t think mutual funds can die, recently Vanguard announced some troubling statistics on the odds of an investor choosing a dying fund. In the period 1997-2011, just 54 percent of the funds managed to even survive the full 15 years. The rest (2,364 funds) were either liquidated or merged into another fund in the same fund family, in some cases more than once. As you would expect, the leading cause of fund failure was underperformance. Funds that failed were experiencing negative cash flows at the time of closure, as investors responded to the poor performance.

Investors had a 79 percent chance of picking a fund that underperformed, was liquidated or had a life cycle that was too convoluted for them to disentangle. For large growth funds, the odds of failure were even higher, at 82 percent. For large value funds it was slightly better, at 73 percent.

Basically, investors should embrace the reality that the odds of owning an actively managed fund that will outperform the S&P 500 Index are significantly lower than the odds of owning a fund that is on its death-bed. Predicated on the facts presented by the Wall Street Journal’s headlines, owning index funds and ETF’s could obviate a Shiva call.