Mark Brandon is the Managing Partner of First Sustainable (http://www.firstsustainable.com), a registered investment advisory catering to socially responsible investors. In addition to Socially Responsible Investing (SRI), he may opine on social venturing, microfinance, community investing, clean technology commercialization, sustainability public policy, green products, and, on occasion, University of Texas Longhorn sports.

Thursday, December 08, 2005

Reason #2 to Fire Your Mutual Fund
Company

Ninth in a Series

The next several posts are going to be dedicated to the proposition that small investors are getting ripped off with mutual funds thanks to a complex scheme of self-dealing and back scratching.

Reason #2 – Technology Eclipses Their Reason For Being

Mutual funds gained popularity for the reasons down below. I maintain that both of them are now made obsolete by technology.

Economies of Scale Mean Lower Costs For Shareowners. On paper, the explanations sound great, but let us look at the evidence. What expenses are involved in running a fund?

  1. Trading Commissions. As I have pointed out in previous posts, this should be the primary benefit, but the evidence shows that mutual funds are not getting better prices than any ordinary investor can get. In fact, in many cases where soft dollar arrangements are concerned (See Reason #10), they are getting far worse. Before commissions were de-regulated in the 1970’s, this factor was reasonable. Getting cheaper commissions meant having a
    technology and trading infrastructure that was too prohibitive for the small
    investor. Today, this technology is available to everybody. Discount brokers use ECN’s to execute their customers’ trades, just like the mutual funds do.
  2. Shareowner Communication such as statements, proxies, confirmations, etc. There are expenses for printing and mailing these confirmations to be certain. However, proxies are only necessary because of the mutual fund structure. Statements and confirmations are required by regulations.
    Your broker sends these for free as part of the commission you paid.
  3. Management Salaries. Certainly, these cost money, but the evidence shows that shareowners are paying way more for these than they
    should.
    A multi-billion dollar fund manager is likely to have a salary in the high six figures if not in the seven figures. Who sets these salaries? The fund board. Although they are supposed to have a fiduciary duty to protect investors, their salaries are probably determined by two factors: their achievement versus the benchmark and their ability to attract assets.
    As we have seen, the latter factor has been more bane to existing shareowners than benefit. So, why is he worth millions, especially when most of them fail to reach their benchmarks?
  4. Administrative Expenses such as office space, office technology, travel,
    lodging, meals for staff, etc.
    Often, these expenses get paid by third party vendors in exchange for trading flow (See Reason #10), and investors end up paying far more for these items than they should. Furthermore, there is no rational reason for the fund manager to be parsimonious with his shareowner’s money. These expenses should come out of the management fee, but instead they are passed on to investors. So, ask your fund operators if they are flying coach instead of first class.
  5. Stock Research. This would be a worthwhile expense if the research enabled the fund to outperform, but as we have seen, it has too seldom been a difference maker. In the last few years, the public has seen
    how little value professionals place on this research. In fairness, it’s difficult for any buy-side investor to know if what is coming out of analysts’ work is worthwhile or fluff.

The second reason for a fund’s existence, as touted by the industry, isnstant diversification. I am absolutely on board with diversification being necessary and worthwhile. But, is getting diversification within the structure of a mutual fund worth the two percent or so that most investors are paying in management fees and expenses? The answer here is less clear, so one must look at the
alternatives. Index funds provide the ultimate diversification at a much lower cost. Exchange Traded Funds (ETF’s) provide diversification, although many of
these charge a management fee as high as 1.5 percent as well. Most of them charge well below one percent, and the biggest ETF’s are in line with the least costly index funds. On this point, the question hinges on whether
active management is worth getting dinged several times what one would be
charged otherwise with passive management. As we’ve seen, very few active managers are able to outperform their benchmarks over the long term.

To see if the mutual fund industry is drinking its own Kool Aid, one need not look any further the long term trend in expenses and management fees. In the last twenty five years, assets under management have skyrocketed from the low billions to approximately $4 trillion today (down from about $7 trillion at the peak of the market). Using their rationale, fund expenses should have decreased dramatically. Instead, they have gradually increased, before you take into account off-balance-sheet expenses such as soft dollar arrangements.

I am an advocate of Folio Investing. This style means that an individual investor, after consulting an adviser, buys into a diversified, asset-allocated portfolio that is appropriate for the individual’s stage in life, risk tolerance, and spending goals. Technology enables us to buy fractional shares of individual stocks, making it possible to create your own little mutual fund without the exorbitant fees and self-dealing. First Sustainable practices this method. I invite you to get a consultation by calling 800-774-3319.

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