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The Great Mutual Fund Trap

How Americans Are Losing Billions to the Mutual Fund and Brokerage Industries-- and How You Can Earn More with Less Risk

The Great Mutual Fund Trap by Gregory Baer
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Convinced that your star mutual fund manager will help you beat the market? Eager to hear the latest stock picking advice on CNBC? FORGET ABOUT IT! The Great Mutual Fund Trap shows that the average mutual fund consistently underperforms the market, and that strategies for picking above-average funds -- everything from past performance to expert rankings -- are useless. Picking individual stocks on the advice of brokers and analysts works no better. The only sure things are the fees and commissions you’ll pay.

Fortunately, the news is not all bad. Investors willing to ignore the constant drumbeat of “trade frequently,” “trust the experts,” and “beat the market” now have the opportunity to do better. Using new investing products investors can earn higher returns with lower risks.

Drawing on their years of Wall Street, Treasury and Federal Reserve experience, Gary Gensler and Gregory Baer offer a fresh and realistic look at how money is managed in America. From new indexing strategies to risk-managed stock selection, The Great Mutual Fund Trap offers investors an escape from high costs and immunity from seductive marketing messages.


From the Hardcover edition.
The Crown Publishing Group; September 2002
352 pages; ISBN 9780767910736
Read online, or download in secure EPUB
Title: The Great Mutual Fund Trap
Author: Gregory Baer; Gary Gensler
 
Excerpt
Chapter 1

Money Management in a Nutshell

Finance, N. The art or science of managing revenues and resources for the best advantage of the manager.
--Ambrose Bierce, The Devil's Dictionary

An Analogy

Every day there is a parade of money managers interviewed on CNBC or featured in Money or similar magazines. Every time we see them, we can't help but think of flipping coins.

Imagine that, instead of picking stocks, these scores of men and women each flipped one hundred coins per day, with the goal of producing the maximum number of "heads" possible. Viewers tune in to see who's doing well and bet on their favorite flippers.

Over time, the flippers' task is essentially hopeless: statistics doom them to an average performance of 50 percent heads. If you observe them on only one day, though, there will be winners and losers. While most will have around 50 heads, some will have 57 or 43.

Now suppose that some of the coin flippers are permitted to raise the stakes of each given flip by taping up to five coins together. For example, if one tapes four coins together, each flip will yield either four heads or four tails. Now, we might expect some of our flippers to produce 60 or 64 (or 40 or 36) heads in one day. By taping the coins, they are taking on risk (the possibility of four tails at once) in return for the possibility of reward (four heads).

Imagine, then, the Coin Flipping News Network (CFNN), giving us twenty-four-hour-a-day coverage of the flipping market. In comes coin flipper Lee with 56 heads, touting her latest tactic--say, many revolutions of the coin, with three taped together. Long forgotten is last week's guest, who had favored the few-revolution, one-coin-at-a-time tactic that worked so well during the last 500 flips but is now seriously out of favor. "Momentum" viewers favor those who have recently had more heads, while "value" viewers favor those who have recently had more tails.

Above all, viewers are assured that they are not capable of flipping the coins themselves--that they must rely on the experts to do it for them. And they are convinced that they should never be satisfied with just 50 percent heads--that is, "market" performance.

The Reality

The current state of money management is similar to this example--only worse. The returns for money managers are like those of our coin flippers. Most tend to stay close to the mean, while riskier funds tend to produce more volatile returns that balance out over time. The difference, though, is that whereas coin flipping is free, money management is not.

For that reason, the chances of your money manager beating the market are small. Evidence suggests that the average actively managed mutual fund underperforms the market three years out of five. According to data at Morningstar (which maintains a comprehensive database on fund performance):

* Through the end of 2001, there were 1,226 actively managed stock funds with a five-year record. Their average annualized performance trailed the S&P 500 Index (a measure of the U.S. stock market) by 1.9 percentage points per year (8.8 percent for the funds, and 10.7 percent for the index).1

There were 623 actively managed stock funds with a ten-year record. Their average annualized performance trailed the S&P 500 by 1.7 percentage points per year (11.2 percent for the funds and 12.9 percent for the index).*

* These figures include the sales loads charged by many funds. Loads are akin to brokerage commissions and come straight out of your returns. They are charged by many funds when you either buy or sell shares of the fund. Even with those loads excluded, however, the average five-year return trailed the S&P 500 by 1.4 percentage points per year, and the average ten-year return trailed by 1.4 percentage points per year as well.

Looking over a longer period of time yields a similar result. Excluding sales loads, the 406 actively managed stock funds that had been around for fifteen years or more trailed the S&P 500 Index by 1.5 percentage points per year.

* None of these aggregate numbers includes failed mutual funds, which would tend to have poorer performance and bring the averages down significantly. The exclusion of these mutual funds is called survivorship bias. The most comprehensive study of survivorship bias concluded that it inflates industry returns by 1.4 percent over a ten-year period and 2.2 percent over a fifteen-year period. With returns corrected for survivorship bias, the average actively managed funds trail the market by about 3 percentage points per year.

How can such a clever, hardworking group of fund managers trail the market by 3 percentage points per year? It's actually rather simple. The collective performance of stocks held by actively managed mutual funds, prior to any direct or indirect costs, generally will equal the performance of the market as a whole. With around $3 trillion in stock holdings, these funds basically represent the market.

But then along come management fees, trading costs, and sales loads. All of these costs weigh heavily on actively managed funds. The failure of almost all money managers to earn back their costs does not make them crooked or stupid. The problem is that their direct and indirect costs severely handicap their performance.

Nonetheless, each year some money managers will outperform the average fund, and even the market as a whole. The question is, can you identify these managers in advance of their market-beating performance? There is no reason to think so. As an individual investor, you have no comparative advantage in choosing those managers. In other words, there is no reason to believe that you will do any better a job picking stock pickers than you would picking stocks. If you can't do the latter, why would you expect to do the former?

Humorist Tony Kornheiser illustrated this point in a column about the trauma of the 2000-01 bear market.

My friend Tom, who has all of his money in mutual funds, panicked when somebody on the Today show said: "Your mutual fund is only as good as the manager investing the money. If your fund changes money managers, you need to check out the new manager." Tom pointed out, "If I was smart enough to check out my money manager, I wouldn't need a money manager."

Exactly!

Most investors simply choose funds based on past performance, but past performance truly is no guarantee of future results. The fact that a fund has outperformed the market for the past year, five years, or even ten years turns out to be a very poor predictor of whether it will outperform the market in the future. Funds that are above average for a time tend to regress to the below-market performance of the average fund.

Let's go back to our coin-flipping example. There were about 1,100 stock funds in 1991, and we know that each year about two out of five such funds (40 percent) have outperformed the market. If the identity of those 40 percent is just like coin flipping--that is, produced by random chance--how many funds would we expect to outperform the market each and every year over the next ten years? (In other words, how many beat the market in 1991, 1992, 1993, all the way to 2000?) Simple statistics tell us that by random chance between 0 and 1 fund should outperform the market each and every year.

That probably seems an improbably low number to you. But what has happened in reality? Over the ten years 1991-2000, only one fund (Legg Mason Value Trust) outperformed the S&P 500 every year. While we are happy for Legg Mason and its manager, Bill Miller, we view that outcome as roughly in line with random chance and as an indictment of active fund management. To the financial media, that outcome is a vindication of active fund management, and profiles of Bill Miller are everywhere. We'll let you decide.

The story is no better when it comes to picking individual stocks. Over a lifetime, the average individual's stock picks should return something close to the market, before costs. Sadly, the research shows that individual investors tend to churn their portfolio in an attempt to beat the market, incurring trading costs and taxes that radically diminish their returns. Investors also fail to construct broadly diversified portfolios, thereby running risks for which they do not receive commensurate rewards. In the end, they wind up trailing the market almost as badly as actively managed funds.

The rise and precipitous fall of Enron--once the seventh largest company in America--has provoked public debate on accounting practices, corporate responsibility, and numerous other issues. But for individual investors, Enron should provide two humbling lessons about the folly of trying to beat the market by picking stocks. First, in October 2001, less than two months before Enron declared bankruptcy, nineteen of the twenty-two analysts who covered the stock rated it a "buy." Critics have charged that these ratings were motivated by the investment banking business that Enron dangled before the analysts' firms. Wall Street has vigorously denied those charges. In fact, Wall Street should have welcomed the allegations as a distraction from an even more embarrassing alternative. The alternative, of course, is that analysts simply don't know a lot more than the rest of the market about the stocks they cover. Enron analysts who testified before Congress claimed that they couldn't be expected to discover problems that the company was deliberately hiding, but we suspect that many investors are relying on them to do exactly that.

The second, greater, lesson of Enron is the value of diversification. Some investors have reacted to Enron by expressing outrage with the accounting profession, corporate governance, and Wall Street; they have questioned whether they ought to invest in a market where Enron-like abuses can go undetected. We can certainly understand investors being outraged, but part of the risk of stock investing has always been that you might end up holding an Enron. Every year, some well-known companies are going to fail. Some will fail because of incompetence. Some will fail because of greed or over-ambition. Some will fail because of bad luck. Some, like Enron, will fail spectacularly because of what appears to be malfeasance. But the cause of the failure shouldn't matter to you as an investor; your money is still just as lost.

What should matter to you as investor is the ability of diversification to protect you against this risk. Diversification insulates you from the failure of any one company or even any one sector. Millions of Americans held Enron stock--but only as part of an S&P 500 or broad-market index fund. They suffered inconsequential damage from the affair, even as those who held Enron as their only investment were wiped out. That's the lesson most worth remembering from Enron.

September 2001

The terrorist attacks of September 11, 2001, were a horrible tragedy for our nation. They also triggered a crisis in financial markets, as markets closed for the week, reopened, plunged, plunged some more, and then recovered by the end of September.

In order to connote the idea of crisis, the Chinese combine the characters for danger and opportunity. Consistent with that view, proponents of active management must have considered the tragic month of September 2001 as holding substantial opportunities for smart money managers. With the airlines and tourist industries in free fall, the mobile phone and defense industries rising, and untold ripple effects emanating from the crisis, there should have been innumerable opportunities for profit in individual stocks. Furthermore, looking at the broader market, active managers could have avoided the general panic selling in the week the market reopened, bought at the bottom, and cleaned up on the recovery.

The actual results for September 2001 refute that idea. The average active manager did not profit. As a group, actively managed stock funds lost more than the market, underperforming the S&P 500 Index by two percentage points (-11.0 percent for the funds and -9.0 percent for the Wilshire 5000 Index, the broadest measure of the U.S. equity market). The largest stock index fund, the Vanguard 500 Index Fund, outperformed 69 percent of all actively managed stock funds for the month.3

As expected, some actively managed mutual funds did perform very well during September 2001. The best performing ones, though, were "bear" or "short" funds that were already betting that the market would go down. These funds didn't quickly internalize the events of September 11 and identify profitable opportunities. They simply continued betting--as they always do--that the market would go down. These types of funds may outperform the market when it's down, but tend not to do as well in the long term. In fact, the ten biggest winners of September 2001 had trailed the market by over 13 percentage points per year over the prior three years. Those that had been around for five years trailed by over 15 percentage points annually.

Many investors turn to active money managers because they want a steady hand on the wheel when markets are in upheaval. Beyond the many more important lessons September 2001 has taught us, it also includes a lesson about active management during a time of crisis: you do a lot better by leaving your investments on autopilot.

How You Can Do Better

"Okay," you say, "so what do I do instead?"

Here, in a nutshell, is how we see it. Everyone investing in the stock market now has a wonderful option. Claim the same returns as the broad market at remarkably low cost, with the ability to defer almost all capital gains taxes. This option exists through traditional open-end index funds and their younger cousins, exchange-traded index funds. It takes minimal effort. It also leaves you free to work more or play more, or a little of both.

We believe that the best analogy to index investing is the generic drug market. Brand-name drugs and their generic equivalents provide the same medicinal benefits. The brand-name drugs cost far more, however, because their owners must recoup the costs of research and development. The generic drug makers incur none of those development costs and instead free ride on the expertise of the "active" drug companies. Informed consumers buy generics. Consumers, however, must wait a few years for a generic drug, as the patent laws were designed to allow inventors (the active drug companies) a period of time without competition to help recoup their research costs by charging consumers high prices.

Index funds are the generics of investing. Because they needn't hire the highly paid stock pickers required for active investing, or pay the transaction costs their strategies impose, they are a bargain for investors. Moreover, "generic" mutual funds, or index funds, are available from the beginning of each market "invention." They adjust daily, even hourly, to track the market prices being established by active money managers. Thus, for stock investors, the free riding can start today.


From the Hardcover edition.
ISBNs
0767910737
9780767910712
9780767910736