For most Americans, mutual funds are the synapse between them and Wall Street. We use mutual funds to place our bets on the future of the U.S. (and global) stock markets, and our retirement hopes ride on the outcome.
That's a monumental responsibility, and many mutual fund firms and managers strive to meet it, placing paramount importance on the long-term interests of individual investors. We try to praise such funds with columns such as
this week's 10 Questions interview.
Unfortunately, plenty of fund firms look out for No. 1 first and foremost in their bid to lure and retain assets. They roll out and relentlessly advertise funds in hot categories that no investor needs, tack on fees that do nothing for investors except lighten their wallet and their managers disregard the fundamentals of investing to chase performance over the short term.
Lots of funds are guilty of this behavior, and it is a great disservice to individuals. Today's column delves into the
Four Things I Hate About Mutual Funds
. Not all mutual funds engage in lousy, self-serving behavior, but plenty do and investors need to know if their funds are among them. Now that everybody feels safe once again to open up their quarterly performance statements because the market is up, look closer to see how many of the following items your funds are guilty of.
1. High Costs
When choosing a mutual fund, most individuals look first for the one thing that doesn't come with a guarantee: recent performance. What they should look for first is a fund's costs. Great performance may come and go, but costs last forever.
In fact, costs are rising. In 1981, the expense ratio for the average stock fund was 0.97%. Twenty-two years later, the average expense ratio is now 1.6%, according to Morningstar. Add in turnover costs and other expenses -- such as 12b-1 fees, through which you foot the bill for your fund's marketing expenses! -- and the average stock fund runs as high as 3% a year. On top of that, scores of funds carry load fees -- sales charges of up to 5.75% on the front end or back end of a purchase. And costs aren't getting higher because life is getting harder for mutual funds -- these firms, the skippers and their boards still make plenty of money, rest assured.
Folks, the greatest thing you have working in your favor as long-term investors is compound annual growth.
High costs are the mortal enemy of compound annual growth
. Why? Consider this example from Vanguard founder John Bogle's great book,
Common Sense on Mutual Funds
. A $10,000 investment that grows at 12% a year for 40 years (good luck finding 12% a year for the next 40 years, but stay with me) would be worth $931,000. Now, lop off the two percentage points for a 10% average annual growth rate, and you're left with a $453,000 -- less than 49% of the value of the 12% return!
Death by a thousand fees isn't going to show up in a quarterly fund statement. But look at your fund's expense ratio, then go to Morningstar's
Web site and see how it stacks up with its peers. Does this fund really deserve to charge you 1.5% to 3% for its returns? Do you really feel you should be paying a 12b-1 marketing fee, even though studies have shown investors get no benefits from them? If not, think long and hard about finding a low-cost index fund or a fund from a family that keeps costs down.
I can think of only two walks of life where failure seven times out of 10 is considered acceptable: baseball and mutual funds.
Now, a .300 hitter in baseball is a beautiful thing -- if the Phillies had two more, they might win the World Series this year. Investing is another matter. Over the past 10 years, only 28.3% of all actively managed U.S. stock funds managed to beat the
; the average fund returned 8.37% a year compared with 10.04% for the index, according to fund-tracker Lipper. Only 10.8% of those funds beat the index by more than two percentage points. (Returns have been much better over five years -- 58.7% beat the benchmark -- but the one-year number drops back down to 32.7%.)
It's impossible for all fund managers to be above average. Despite the persuasive arguments of index-fund devotees who say that, statistically speaking, actively managed funds are a loser's game, I still invest in a few actively managed funds from top-shelf fund firms. However, it bothers me that so many fund firms seem to be comfortable with routine underperformance, which also reminds me of baseball and the economics that some teams exploit. Some sports teams' owners -- the Phillies' management a few years back, for instance -- got comfortable fielding a bad team because they could still get 2 million loyal fans to attend games.
Be true to your sports team. But if your fund has a long history of lousy performance, throw 'dem bums out.
3. Herd Mentality
I have written before about
institutional herding, and it's a subject that bears repeating. Sadly, there are scores of mutual fund managers who, due to a variety of internal and external pressures, find that safety in numbers offers more job security than profiles in investing courage.
A decade ago, fund managers might say, "You won't get fired for owning
." In the late 1990s, you could replace GE with
. These days, a fund manager wouldn't get fired for buying
at current prices -- two great companies, but they sport P/E multiples north of 100! And it's true; they won't get fired. Besides, it's only (your) money.
Individuals should invest with mutual fund families and managers who march to their own tune rather than follow the pack. That means sticking with those funds if they posted a 10% return in 1999 when other funds where posting triple-digit returns. How to tell if your fund firm sticks to its guns? A look at their top holdings often provides insights into their thinking; also, check out the firm's Web site. Great shops like Dodge & Cox, Matthews, Ariel and Mairs & Power may not have bells and whistles on their Web sites, but they all make sure they spell out their disciplined investment approach loud and clear.
4. Excessive Turnover
While there's nothing wrong with active trading, too-active trading can be a big problem. Forty years ago, a fund's turnover rate rarely exceeded 16% a year. Today, the average fund manager's turnover rate is 110% -- meaning the average fund completely sheds its skin every year.
Yes, the stock market is worlds different than it was during the Kennedy administration. What's the big deal? Well, costs, for one. Every time a fund manager trades, the costs get passed on to you-know-who. Thanks to skippers with itchy trigger fingers, turnover costs now run about 0.8% a year. Another big downside to overly active management: It undermines the notion of long-term investing. Whatever happened to buy and hold?
Legg Mason Value Trust manager Bill Miller, the only skipper to beat the S&P 500 for 11 years running, noted in December that his fund would have performed better in 2002 if it had remained "turnover free" -- making no trades for the year. His research team went back to 2001 and learned that a turnover free fund would have done better over two years as well. The lesson: Go on Morningstar or check your fund's statement to see what the turnover level is, especially funds that are held in taxable accounts. A few rare funds have higher turnovers but have managed to trade judiciously and successfully. However, as a general rule, a high turnover rate isn't a good thing.
Before individual investors get shocked -- shocked! -- by the increasingly active management at their funds, they should look in the mirror. Individuals have become a danger to themselves because they too are trigger happy when it comes to buying and selling funds. Since 1984, investors held funds for an average of two years, according to Dalbar. The average investor earned a mere 2.57% annually during that time, compared with 12.22% for the S&P 500.
Investors should be wary of hyperactive fund managers, and they should keep themselves in check, too.
Note to readers: This list only includes four things I hate about mutual funds, but there are plenty of other rampant problems. What do you hate about the fund industry? Email me at email@example.com.