Mutual Funds: December 2005 Archives

Reading the papers, I see all kinds of garbage about mutual funds. Probably the biggest single piece of garbage is that only the so-called "no load" funds are any good. They focus only on the cost of the "loaded" fund, as if there is no benefit to be had from the fact that the "load" pays a professional advisor to help you out. Indeed, it has been well established by DALBAR that net returns of investors with paid advisors, in aggregate, tend to significantly outperform those of investors without.



It's not just investment knowledge, no matter how much people protest that they know every bit as much as the professionals. If you aren't, you don't. It's investor psychology and not being so emotionally involved in the problems and knowing what to do in the first place so as not to spend so much of your money on basic mistakes. This isn't play money you're working with, and if it was, the experience wouldn't help when it came to making real investments. When you don't get do-overs, and the time you've lost and wasted is the worst thing about the situation, and when the average investor makes three avoidable mistakes costing twenty percent or more of their portfolio value, five percent plus a quarter of a percent per year doesn't look like such a bad investment. On the same theory that a lawyer who represents himself has a fool for a client, show me a financial adviser who handles his own "big money" without paying for advice and I'll show you an adviser to stay away from.



With that said, some people are bound and determined to do it all themselves. That's fine, so long as you admit to yourself that it's likely to cost you money, and that the ego thing is more important to you than the money.



What I look for, what most professionals look for, in a mutual fund family, is three things. Good Asset Class coverage. Sticking to a fund's stated modes. Willingness to change a fund management if the performance lags the class over time.



Good Asset Class coverage has to do with the standard categories of funds. Small versus large versus mid cap. Value versus Income versus growth. Bonds versus stocks. I want to see funds within the family that "hit the corners". Large Cap Growth, Small Cap Growth, Large Cap Value, Small Cap Value, Investment bond, Government bond, "High Yield" bond (aka "junk"), Income, and preferably multiple international choices as well. I may not put money in every category, but I want it available to me. I insist that Value be Value, not "growth and income." Real Value funds are harder to "sell" laypersons on, but long term, they tend to outperform growth.



The second thing I want is that the management sticks with the fund's asset class, and doesn't play funny games with the definition. I don't like funds that break type to chase today's returns. A full explanation as to why is beyond the scope of this essay, but For a quick illustration: A few years ago, there was a very hot no-load fund family. Literally top of the demand curve. Everyone wanted their funds. They advertised like hell to attract business, and it worked. They got almost fifty percent of the money coming into mutual funds for a while - and every single fund of theirs put their money into basically the same companies. I did a comparison on them and could not find two of their funds with less than a forty percent investment overlap. This was basically using increased demand to drive price, and hence, temporary paper returns. But this couldn't last, and they went from being the darlings of the market to absolute bottom in one year.



The third of the most important things that I look for is willingness to replace a bad fund manager on behalf of the family management. I'm not looking for immediate replacement if they lag the class for one quarter. I'm looking for family management that is willing to replace someone that consistently lags the class over time. This is harder to get than you might think. Typically by the time that someone has risen to fund manager, they've been with the family for a while and know where most of the bodies are buried. "Charlie" who heads the family goes golfing every week with "George" who's doing a rotten job and deserves to be replaced, but you don't fire your golfing partner. It's all among friends, right? Well, no. It's my money this clown is wasting.



There are a couple other things that are highly beneficial. Limited number of investments, preferably a maximum number set in the prospectus. Twenty to thirty investments is the optimal tradeoff between diversification and dilution, and most funds are too dilute. Availability of Sector funds is also a big plus. But none of them is as important as the big three.



Caveat Emptor.

It seems I can't hardly turn around in the investment world without a paean to Jack Bogle, who preaches the advantage of the index fund.



Mr. Bogle's reasoning goes something like this: Looking at the world of mutual funds, relatively few funds beat the S&P 500 Index, so why not just buy the whole S&P Index?



This is nothing short of the most successful sales pitch based upon a straw man argument in history.



Index funds are huge. Mr. Bogle's own original fund is the largest mutual fund, and both of the two largest mutual fund families base their pitches (in large part) upon their large number of Index Funds based upon various indices. That's how successful the pitch has been.



What Mr. Bogle doesn't tell you is that Index funds aren't the Index either.



There's a bit of Red Herring in the argument also. Index Funds aren't some ideal investment package that doesn't have expenses. They may be low (21 basis points per share for the biggest the last time I looked), but they are there. So in an ideal universe, they lose to the index by this amount. Plus they do have the same need managed funds have to hold some cash. Since the market goes up about 72 percent of the time (over the course of historical years), and they lose an amount of gain or loss proportional to their cash holdings, over time they lose more than they gain on this. By comparison, the measurement made of managed funds is after all such ineffieciencies.



In other words, the Index Fund sales pitch reduces to "Most of these other finds don't beat this measurement. Come to us where you're guaranteed to fall short!" The thrust of their sales pitch is holding themselves out to a a perfect idealization, which in fact they are not.



There are other reasons to avoid Index Funds. The most famous, best known and largest are all built upon the S&P 500 Index. This is a market capitalization based Index. The Fund buys into these companies based upon market capitalization. It should be no surprise to anyone that this means that whatever the largest company in S&P is, it will be several times the size of number 500, so the funds investment in them will be correspondingly weighted, while having zero investment in number 501. This means (because Index funds are such a large portion of the overall market) that Index Funds cause demand for those companies which are a member of this universe to have larger demand than they otherwise would, therefore artificially inflating the share price of those companies somewhat.



Now, one of the reasons people gravitate towards mutual funds is instant diversification of investment. You put in your $1000, and because it's is in turn invested as a part of a much larger investment pool, you have much more diversification than you would otherwise be able to purchase with that same investment were you to purchase stocks directly. One of the reasons I worked almost exclusively with mutual funds (and mutual fund-like) when I was in the business is that if you want to build a diversified direct stock portfolio in an efficient manner (buying whole, as opposed to odd share lots), it takes about $100,000. This is more than most folks are willing or able to invest in a single shot.



But one of the open secrets of the mutual fund industry is that many, if not most, funds are over-diversified. Their holdings are so diluted that when they pick a winner, their shareholders see comparatively little benefit because they've made too many bets. When you bet 100% of your money and the stock doubles, you get 100%. When you bet 1/500th of your money and the stock doubles, you get 0.2%. This dilution effect is directly proportionate to the number of investments (bets) they have made, while the benefits of diversification are only proportionate to the square root of the number of investment holdings they have. In other words, the fund with 400 holdings is sixteen times more dilute than the fund with 25, but only four times as protected by diversification. One of my favorite fund families, in which I myself continue to invest for other reasons which outweigh this, had 432 holdings in its growth fund the last time I got a report. That is way too many. Mathematical models have determined that the optimal number of holdings for a fund is in the range of twenty to thirty, getting good protection of diversification while not suffering from over-dilution of good investments. I am becoming, more and more, a fan of "focus" model funds, where the investment managers are forced to be choosy by limiting the overall number of investments to a certain number of securities.



Index funds typically have way too many funds to qualify for this. Of all the major indices, only the Dow Jones ones have a small enough base to be considered as having a near optimal number of components. I just don't hear about people wanting to invest in those. 20 Transportation? 15 Utilities? They're derided as sector investments, and not good ones. 30 Industrials still seems to have some cachet, but by comparison with S&P 500 or even the Russell Indices (1000, 2000, and 3000), the amount invested in Dow Industrials is microscopic. Perhaps because it's not a "true" index, but is selected by the publishers of the Wall Street Journal, theoretically for the components representation of the entire market.



Index funds are not without their benefits, of which their mindless vanilla nature is probably the greatest. If you want an investment you can just make and not watch and not worry about unless the entire asset class tanks, Index funds are fine (S&P is large cap blend). For market-timers, index funds are unmatched, particularly since their cost of putting the investment in and taking it out tends to be low. But I am not a mindless vanilla investor, and for one step up the mental chain, index funds can be beaten by periodic investment class reallocation. Furthermore, I am an investor, not a market-timer. So any time somebody's recommendations for investing include index funds, I'll pass them by.



Caveat Emptor.