Busting the Mutual Fund Myth

My friend and ace market strategist Tony Dwyer at FTN Midwest Securities likes to incorporate the MythBuster theme into some of his articles. MythBusters is a cable TV show on the Discovery Channel that we both enjoy watching with our sons. Several years ago, independent of Dwyer's articles (which I avidly read), I developed a lecture for my undergraduate class at Seton Hall titled "The Mutual Fund Myth."

Last time at TheStreet.com University, I discussed the range of variables involved in mutual fund investing. I mentioned the Mutual Fund Myth, and now we are ready to discuss that in greater detail. By the end of this article, you might think twice about how you invest in mutual funds and, hopefully, will become a much better mutual fund consumer.

The Mutual Fund Myth

The three basic tenets of mutual fund investing are:

• Low cost due to economies of scale.
• Diversification.
• Professional management with performance as an objective .

There is some doubt as to whether those basic tenets hold true in the real world. I will consider them one at a time.

Tenet 1. Economies of Scale

The theory behind a mutual fund is that by aggregating assets under a single entity, investor expense ratios should decline as the assets in that fund rise. We need to understand that expenses take two forms: fixed and variable. An overwhelming preponderance of the costs charged to mutual funds and their investors are variable in nature, such as management fees , loads and trade commissions . Trading commissions are embedded in the execution cost of the fund's transactions and hence are not part of the expense ratio, but they will have a fingerprint in the fund's returns.

As an institutional client (or institutional investor ), mutual funds will pay a per-share execution charge, say, 5 cents, that will be the same if it trades 10,000 shares or 1,000,000 shares. Other expenses are fixed or hybrid (part fixed, part variable), such as legal, accounting, regulatory, custody, non-adviser expenses and 12b-1 fees . As the fund's assets grow, the impact upon the NAV (or net asset value) of these fixed and hybrid costs should decline.

In its December 2006 issue, Financial Planning Magazine published an article titled "Economies of Scale?" This article, written by Craig L. Israelsen, sought to validate mutual fund economies of scale on the basis of research conducted by the author. Israelsen stated, "rising net assets did not correlate -- at least by much -- with falling expense ratios ." Israelsen discovered that by using the 124 most prominent funds in the U.S., "the mean expense ratio for these funds declined by 8.6%, while the median actually increased by 3.5% (from 0.85% in 1985 to 0.88% in 2005)."

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