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)."

Tenet 2. Diversification

Diversification is also a very subjective term. You must first define what index or asset class that you are diversifying against. Second, you have to worry about single stock concentration. Perhaps you don't really care. It really is a matter of choice and risk-aversion, but you need to know what the profile is of the fund that you own.

Example: Legg Masson Value Trust

Below is some descriptive risk information for the Legg Mason Value Trust ( LMVTX), which I obtained from Bloomberg:


Source: Bloomberg

Click here to see a full view of the chart.

As we can see in the chart, the top 10 holdings represent 44.96% of the mutual fund's assets. Each of those 10 holdings vary in weightings from 3.472% to 5.236%, but given the average is 4.496%; the variance of the relative weighting to the naked eye seems be rather low. Finally, the beta of the fund relative to the S&P 500 ( SPX) is 1.02 or 102%.

On the other hand, according to Bloomberg ( click here to view the chart), the First Israel Fund ( ISL), a closed-end fund, has a totally different risk profile. The top 10 holdings account for 58.92% of the fund's assets, with the top holding, Teva Pharmaceuticals ( TEVA) representing nearly 15% of the fund's assets. The beta is 0.75 but then again, this fund is not designed to track the SPX.

As it turns out, I own ISL and have done so for several years. However, I own it with the objective of exposure to Israeli investments and with the full realization that I am not getting the diversification afforded by other funds.

Tenet 3. Professional Management and Performance

There is an interesting dichotomy that is quite apparent in the mutual fund industry. On one hand, mutual funds are managed by professional investment advisors with the primary objective to outperform a target index. On the other hand, the professional investment advisors make their money by charging a fee on assets under management and are thus motivated to aggregate more assets, especially in open-end funds.

These objectives create a diametrically opposed force upon the mutual fund. As assets rise, the ability to diversify and outperform an index will become increasingly more difficult.

In fact, when mutual funds hit a critical mass, usually several billion dollars, they become a proxy for the market portfolio. Thus, you wind up paying a large sum of fees for active management on what becomes a passive market portfolio.

To combat this problem, the investment advisor has to reduce expenses and take on more risk in order to outperform the desired benchmark.

Some funds may be successful at surmounting these issues such as the $68 billion Dodge & Cox ( DODGX) value oriented fund, which despite sporting a 0.99 beta has an excellent track record of outperforming the SPX as we see below:


Source: Bloomberg

Click here to see the full view of this chart.

The American Fund Investment Company of America ( AIVSX), with over $88 billion in assets, is another value oriented fund. AIVSX managers have taken a different approach to try to outperform their benchmark but have been less successful in that effort vis a vis DODGX despite the lower beta of 0.94 as we see below:


Source: Bloomberg

Click here to see the full view of this chart.

The answer in many people's minds to this cost/benefit predicament is to invest in index funds and exchange-traded funds. By design, these funds will underperform the benchmark target because of their cost, nevertheless those costs are minimal and the underperformance is negligible.

While we are not quite done with the Mutual Fund Myth (there is more to come at a later date), we have now dispelled (or busted) some of the most widespread myths associated with mutual funds. Understanding how to navigate these myths will make you a much better investor.

Key Points:
  • Don't assume that just because a fund is big, your costs will be less than a smaller fund.
  • Don't be ensnared by the trappings of diversification. A fund's objectives, risk metrics and portfolio weightings can make or break your portfolio.
  • While you're often warned that past performance is not indicative of future returns, there is still a reason for a fund's past performance. Comparison shopping and homework are required.
  • Index funds or ETFs can offer competitive alternatives to large mutual funds.

Some Homework:
  • Before you invest in a mutual fund (regardless of its size), check the fund's cost structure.
  • Analyze each fund's objectives, risk metrics and portfolio weightings. To review this data, go to publicly available sources, such as the fund sponsor, Yahoo! Finance, Bloomberg or Morningstar.
  • Compare the performance rates of a wide-range of funds (and understand what really drives those rates).
  • Consider shifting assets out of large-sized mutual funds into index funds or ETFs.

You can email me your homework and your thoughts on the subjects covered in this article. I will compile the best ideas in a future module of TheStreet.com University.

At the time of publication, Rothbort was long ISL, although positions can change at any time.

Scott Rothbort has over 20 years of experience in the financial services industry. In 2002, Rothbort founded LakeView Asset Management, LLC, a registered investment advisor based in Millburn, N.J., which offers customized individually managed separate accounts, including proprietary long/short strategies to its high net worth clientele.

Immediately prior to that, Rothbort worked at Merrill Lynch for 10 years, where he was instrumental in building the global equity derivative business and managed the global equity swap business from its inception. Rothbort previously held international assignments in Tokyo, Hong Kong and London while working for Morgan Stanley and County NatWest Securities.

Rothbort holds an MBA in finance and international business from the Stern School of Business of New York University and a BS in economics and accounting from the Wharton School of Business of the University of Pennsylvania. He is a Professor of Finance and the Chief Market Strategist for the Stillman School of Business of Seton Hall University.

For more information about Scott Rothbort and LakeView Asset Management, LLC, visit the company's Web site at www.lakeviewasset.com. Scott appreciates your feedback; click here to send him an email.