Open Book: Mutual Fund Investors Beware

I have always been a devotee of Benjamin Graham and David Dodd's value approach to investing. After the dot.com bubble burst, I wondered whether the value funds -- ones that invest along the lines of a Warren Buffett -- had bitten on the tech and media stocks that had been all the rage in the late 1990s.

Remember, it was the New Economy, and no one needed an excuse to buy Broadcom (BRCM Quote), Enron, Oracle (ORCL Quote) and the like. An excuse? You needed an excuse not to be in such stocks.

Given the names of 10 true-blue value mutual funds by a manager who himself is deeply committed to investing on fundamentals , I decided to see, first, if the group had steered clear of a Fortune list of high-flying stocks -- ones selling at prices that bore little relationship to earnings , if indeed they had earnings. And then, the acid test, to see how the group performed over a five-year period that encompassed both the bubble and the collapse.

As it turned out, they passed both tests with A+ grades. They had stuck to their principles, uniformly avoiding the Enrons of the day. And over the five-year test period, they far outperformed the market, each and every one of them.

A year later, in 2005, speaking before the New York Society of Security Analysts , I updated the value funds' results. I also compared those results with a mainstream group of large capitalization growth funds , the 15 survivors of the 20 largest such funds at year-end 1997.

Again, the results were remarkable: the value funds outperformed those 15 large-cap growth funds on average by 18% per year. But it was not just the performance that was striking. The value funds were very picky, investing in just a few selected stocks and then holding them for years. The more mainstream funds held huge portfolios, which they turned over at a fast clip, trying to catch the next new thing.

Now I was off in a universe radically different from those value managers where I had begun. What captured my attention was the management of funds, or rather the mismanagement of them. Why were the major fund complexes proliferating new funds so rapidly that, even as I wrote, hundreds of new stock funds came on stream?

There is a profound conflict of interest built into the industry's structure, growing 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.

A fund family may have 100, even 300 different funds, to reach every niche in the market. 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.

After the market-timing abuses were uncovered, many of us hoped we had seen an end to the corruption. What I found instead was a continuing story of incompetence and indifference, aggravated by greed and dishonesty. Investors have been used and misused, not just by outright thievery but also by the fact that so many fund sponsors, and the brokers and other financial advisers through whom they market, are far too ready to manage monies, to steer their clients, in ways that violate the trust placed in them. That's the betrayal about which The Investor's Dilemma is written.