Mutual Funds a ripoff?

Maybe that’s pushing it a little bit, but the fact is that the vast majority of mutual funds, mostly actively managed, add more in costs than they do in value.  A net loss to the investor compared to what he should be paying.

David Swenson, chief investment officer at Yale University (he manages their huge endowment) and author, wrote an opinion piece in the New York Times Sunday Review recently and discussed this very issue.  The article is very well worth reading and may be found here:

http://www.nytimes.com/2011/08/14/opinion/sunday/the-mutual-fund-merry-go-round.html?pagewanted=all

Swenson points out some important facts in there, and refers implicitly to plenty of studies which support his conclusions — that investors have been losing out and the mutual fund industry (and those “advisors” who push clients into these funds so often) are making out like bandits.  He then goes on to make some specific recommendations as to what should be done about this.

One important thing to note is that, as Swenson says “Even Morningstar concludes, in a remarkably frank study, that low costs do a better job of predicting superior performance than do the firm’s own five-star ratings.”  In other words, costs matter.

Before we go on to Swenson’s recommendations, it’s worth explaining a little bit about that.  Costs matter — within an asset class.  You can’t compare performance between asset classes nearly as well.  Nobody expects a money-market fund to beat an equity fund over the long term (though they should expect the money-market fund to have no volatility or and almost no risk).  So a low-cost money-market fund shouldn’t be expected to beat a high-cost actively managed equity fund in the long-term.  That’s apples-to-oranges.  But if you are comparing two money-market funds, or, say, two large-cap value equity funds, costs have done a remarkable job of predicting which fund within a given category will have done better over time.

Swenson’s specific prescriptions:

1. Individual investors should avoid sales pitches and invest in a well-diversified portfolio of low-cost index funds

2. The SEC should encourage this.

3. The SEC should hold the mutual fund industry to a “fiduciary standard” which puts clients’ interest first.  Retail brokers operate under a weaker standard (“suitability”).  Note that Registered Investment Advisors do operate under a fiduciary standard, but it can be confusing because certain financial professionals wear two hats – one “RIA” and one “broker” and it’s not clear at any given time which hat the person sitting across the table from you is wearing.  If you’re not sure, ask.  And if you’re still not sure, make sure the person you are working with is not a broker and is *always* held to that fiduciary standard.  That means look for a “fee-only” advisor.  Beware of anyone who is “fee-based” or who gets commissions.  Not all “fee-based” or commission-based folks are doing wrong by their clients, and not all “fee-only” folks are always doing right.  But at least the “fee-only” folks are more likely to be held to the existing fiduciary standard.

Addendum: Henry Blodget doesn’t pull punches as he claims “The Mutual Fund Industry Is A Huge Scam That Costs Investors Billions Of Dollars A Year”.  Read his article over at Business Insider here:  http://www.businessinsider.com/david-swensen-mutual-funds-2011-8

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