The collapse of the tech bubble and the downfall of
exposed the failings of a lot of mutual fund managers. For one, it seems as if many of them simply don't know how to pick stocks. But the fund business still harbors plenty of dirty little secrets.
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Fund managers have concocted various ways to avoid actually working and devised several tricks to enhance their performance. If you're a waiter, you might hide behind a dumpster in the middle of your shift, smoking a cigarette. If you're a fund manager, you copy your benchmark index and then surf the Internet all day.
Several current and former fund managers agreed to confess some of their industry's sins -- as long as they remained anonymous. If those losses in your funds weren't enough to enrage you, keep reading.
Dressing Up a Fund's Holdings and Returns
Near the end of the month or the quarter, plenty of fund managers will load up on the stocks that have done well and trim any losers to make their portfolios presentable. The idea is to make a fund's top holdings look like a list of winners. It's a common practice known as window dressing. "You do this quite a bit," says one manager. "You look at the top 10 and ask, 'Is that what I want to show the world?'"
But as a shareholder, you can look through a fund's reports to find any losers that lurk in the list of holdings and read the manager's commentary on which stocks hurt (and helped) performance. However, there's another quarter-end trick that's impossible to spot.
To enhance their quarterly performance numbers, some managers will use extra cash to pump up the prices of stocks they already own. Here's how it works: A manager will take any cash on hand and buy more shares of less-liquid stocks in the portfolio. That additional buying can push the stocks higher and improve a fund's overall return. In a stock that's thinly traded, an order of a few hundred thousand shares could make a difference. Then, after the quarterly performance numbers are calculated, the manager can pare back the position. Hopefully, the stock doesn't blow up in the meantime.
Securities regulators see this game as stock manipulation. It's a career-ending event if you get caught. But it still goes on.
An Index Fund in Disguise
At least this trick to boost returns takes a little bit of effort. Other managers are just content to sit back and lazily run a fund that looks almost exactly like a broad index, such as the
"Say I have a multibillion dollar fund that's gotten so big that it's hard to really outperform," says one fund manager. "I have a big fund, and I don't want it to blow up. I can link 90% to the index and then play with the remaining 10%. Well, I am fat and happy. I can go into maintenance mode, come in half an hour before the open and leave at the close."
And performance relative to a benchmark like the S&P is used in calculating the pay of many managers. And it's easier and safer to construct a portfolio that looks a lot like that index than to take risks on a few lesser-known stocks. That's one reason you'll see
in so many actively managed funds. It's one of the largest stocks in the S&P 500, and managers simply have to own it.
You can spot this ploy if you closely watch a fund's performance. If you own a fat large-cap fund whose performance rarely diverges from the S&P 500, then the manager might be mimicking that index. And why pay extra money every year for stock picking if you can get about the same performance with a cheap index fund?
If It Looks Good, I'm Buying
Rather than mimicking an index, a fund manager can copy other managers. Money management professionals admit they know many managers who don't really understand the stocks in their portfolios.
Managers will look at where the money is flowing, notice everyone is buying a certain sector and then just pile right in. A particular industry is hot, and the manager might go to the firm's designated analyst in that sector for some quick recommendations. "A manager might say: Hey, health care services is hot. Can you give me a few names? It could be any sector. Just fill in the blank," says one fund company executive. "I am always a little disturbed when I see a manager who doesn't really know what he owns."
I Trade Because, Well, I Like to Trade
And then there are the managers who would rather trade than research stocks. "Some guys are addicted to the action of turning the portfolio over," says one manager. "Part of it is because they're bored, too."
Unfortunately, excessive trading can be a performance killer. The costs of trading, such as commissions, come right out of a fund's returns. And the manager might also be realizing taxable gains, which are passed on to shareholders every year. And then there's the likelihood that the manager is buying high and selling low.
"If you own a large-cap, blue-chip fund that has 100%-plus turnover, I would question that," the manager says. "Your turnover shouldn't be that high."
A manager who is looking for action might try waiting tables for a while and save the shareholders some money.
In keeping with TSC's editorial policy, Dagen McDowell doesn't own or short individual stocks, nor does she invest in hedge funds or other private investment partnerships. Dagen welcomes your questions and comments, and invites you to send them to