Reason #4 to Fire Your Mutual Fund Company

Seventh 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 #4 - Short Term Speculation

For most of the history of the Mutual Fund Industry average annual turnover hovered around 15 to 20 percent. This means that 15-20 percent of the funds portfolio changed each year. Put another way, the average holding period for a stock in a mutual fund portfolio was 8 years. Starting in the late 1970's and accelerating in the mid-1990's, average annual turnover is now 100 percent. Put another way, the average holding period is now less than one year. So, while preaching that a steady, long term approach was appropriate for their customers, the industry has itself moved from a stock-ownership mentality to stock-rental mentality.

I am going to save for another day the discussion about how this makes it more difficult to achieve results commensurate with the enormous fees levied. Be aware that this is aspect is the biggest problem with a short-term mentality. However, there are quantifiable reasons to avoid high turnover.

How High Turnover Hurts You

I keep returning to this point. High fees and expenses are the primary reason that mutual fund performance lags their benchmarks. Some are more transparent than others:

1) Trading Commissions. This is not disclosed in the fund's expense ratio, making it harder to compare the true costs among funds. As I've mentioned in previous posts, you would think that a sizable mutual fund would be able to get competitive commissions, but in actuality, many of them pay far more than any individual can get, thanks to soft dollar arrangements (See Reason #10).

2) Taxes. If a fund manager sells a position for more than was paid, the fund is obligated to pass that through to investors (see Reason #8). If the holding period was less than one year, the gain goes into the "short term capital gains" basket. This is taxed as ordinary income. If the holding period was more than one year, the gain goes into the "long term capital gains" basket, which has a lower rate. So, if your fund has an abundance of short term capital gains, you are paying up to 250 percent more in taxes for short term gains than long term gains.

3) Spreads. Almost all stocks have a spread. When you see a price quoted with a bid (the price at which you can sell), and the ask (the price at which you can buy). The difference is the spread. On the most liquid stock, this amounts to pennies per share. On the lower-volume and international stocks, the spreads are wider. This can amount to a serious drag.

4) Slippage. This refers to the difference between the price that was received for a buy or sell order, and the price at the time the order was given. For funds with sizable positions, you can bet that heavy buying will raise the price, and heavy selling will lower the price. Even relatively small lots of 1,000 shares will move the market in the less liquid stocks, so imagine how this affects a multi-billion dollar fund.

None of these factors are figured into the expense ratio that was quoted in the prospectus or other marketing material.

How We Got Here

Many factors contributed to the rise of speculation among the stewards of your nest egg, some understandable, some nefarious.

1) The deregulation of commissions. The 1974 rule-change dropped the bottom out of the cost of executing a trade. This made short term trading more feasible, but it also created a need for Wall Street to substitute the lost revenue. They found it. In 1970, the average daily volume was 15 million shares. In 1990, it was 300 million. In 2000, it was 3 billion.

2) The rise of IT. Computer technology enables quants (the wall street term for a manager who makes trading decisions based on computer algorithm) to plug in a vast array of data points into their systems. The result is a whole lot more buy and sell signals.

3) Captive mutual funds trading through parent-company brokerage operations. This allows fund companies to pass some vigorish on to their corporate parent without disclosing it.

4) Soft dollar arrangements. Managers are showered with perks in order to direct more volume the way of brokerage houses.

What To Do

The body of academic studies makes one thing painfully clear. There is an inverse relationship between average annual turnover and fund performance. You would have to think that otherwise bright fund companies would know this, and adjust their fund management styles accordingly. Unfortunately, I think the evidence tell us that they do know about it, but that changing their style means less in their pocket.

Tomorrow: Reasons #3 - Chasing Performance