Phipps Lane

Why Mutual Funds Destroy

Your Investment Returns

The financial industry is more concerned with making their own profits, rather than serving shareholders. That is no surprise to most of us.  As a result we suffer low returns, high risks, more fees, and greater taxes than we should.  Here are an amazing 25 common business practices that hurt us all:

• Frequent manager changes—half of the Mutual Fund managers stay for only 3 years, 20% less than 2; new managers often change the nature of the fund without shareholder knowledge or consent. No one notices because changes are only required to show up in the prospectus (which no one reads anyway!)

• Moonlighting managers—in 2006 450 Mutual Fund managers also ran Hedge Funds; 206% more than in 2002, according to Morningstar.  With higher fees in hedge funds, this causes a conflict of interest, boosting the Hedge Fund returns at the expense of the Mutual Fund.  One way they get away with this is by “cherry picking”: buying a stock; then based upon its short-term performance, deciding after the fact into which vehicle it will be placed, the Hedge or the Mutual Fund—disgusting.  Or buying in one fund, while selling in the other.  When there is an overlap in managers, on average the Hedge Fund outperforms Mutual Fund by $1.20 (according to Wharton/William&Mary/Mason 10 year study).  With no overlap of managers (according to Greenwich) assets: the average Hedge Fund exceeds the Mutual Fund in their respective brokerage commissions $33MM versus $16MM

• High turnover—Mutual Funds hold of stocks on average only 6 months. This turnover increases brokerage costs, and the “bid/ask spread” thus decreasing returns

• Style drift and bracket creep—selling leads to replacement with a totally different kind of stock.  University of Missouri, and Northwestern University studies show that over ½  of Mutual Funds drift from their stated investment objective.  “Magellan” made bad and big bets to overweight bonds, betting interest rates would decline; result — BIG losses.  The SEC says 80% of assets must conform.  This may also lead to closet indexing

• Excessive cash or margin—in ’02 Carpenter Analytical showed only 85% of funds invested, resulting in truncated performance; and derivatives or margin are gambling and speculation, not investing.

• Window dressing—buying the stock after it has risen for publication purposes

• Misleading names—Yale thinks it is 54% “growth” or “mid-cap” may not be

• Cosmetic name changes—the new name boosts AUM

• Closet indexing—1 in 3 according to Yale, ’06.  Investment Advisor calculates a real cost of 5.2%  per year

• Funds that re-open and close—by announcing closing to new investors, a flood of new ones pour in to beat the buzzer.  Then after it re-opens, the press release results in further new investors.  A marketing gimmick..  The closing is supposed to be for more efficient management.  But it is only closed to new.  Existing continue to pour money in, with continued inefficient management.

• Fund bloating—always results in closet indexing.  Big funds have to buy big stocks so they don’t overwhelm the markets, influence share price

• Cloning—a ploy to attract new investors.  Supposed to be just as good, it may have different objectives, and/or different managers.

• Survivorship bias—poor performance cause its demise thus misleading investors about a fund family’s overall performance.  This can trigger tax liabilities.  It is worse when merged into a pre-existing MF.  These occur with no warning.  Over 5000MF’s terminated or merged 2000-2005.

• Incubation strategy (creation bias)—the strategy is to create a bunch, see which performs well.  Bad performers are terminated.  Good reported to Morningstar after 3 years.

• Fund seeding—IPO’s are offered. The family buys, then if it performs well, allocated to selected MF’s

• Confusing share classes—and you might buy one class only to be automatically converted to another

• Hidden fees—all charge fees.  E/R operating costs are reported in the prospectus.  Avg = 1.33%, but some can be 3-15%.  This is never noticed because it is debited daily and does not appear on any statements. But Wake Forest and UF showed that 44% of fees are not disclosed (except in the Statement of Additional Information, which is more cumbersome than the Prospectus) e.g. trading expenses applied to high turnover, and B/A spreads often add >1.25%.  80% of Yale, Harvard, Wharton MBA students could not find the cheapest MF’s by reading the prospectus.

• Stale pricing—T+1 accounting can change a 4.7% daily loss into only 0.7%, or even a 3.7% gain into 5.3%.  This is done by calculating the day’s closing prices to the stocks held the day before.

• Rising costs—in 50 years avg N/E/R  inc 0.75-1.33%, plus the other expenses

• Illegal market timing—remember that?

• Late trading—remember that?

• Personal trading by manager—buying for a MF while selling in personal portfolio

• Steering business—trading costs for example for payments to the fund family

• Shelf space payments—to be approved by a wholesaler, must pay “due diligence”  “annual conference” and “application” fees.  This adds 10’s of millions of profits into their coffers.  It is the best way to “move” “slow inventory”

Source Ric Edelman’s Lies About Money