Mutual Funds

Here's the mutual fund article I promised you yesterday.  {Excerpt with my highlights.}

The Mutual Fund Merry-Go-Round

By DAVID F. SWENSEN    Published: August 13, 2011

AS stock prices have gyrated wildly, many investors have behaved in a perverse fashion, selling low after having bought high. Individual investors bear some responsibility for ill-advised responses to the ups and downs in the market, but they are not the only ones to blame. For decades, the mutual fund industry, which manages more than $13 trillion for 90 million Americans, has employed market volatility to produce profits for itself far more reliably than it has produced returns for its investors.

Too often, investors believe that mutual funds provide a safe haven, placing a misguided trust in brokers, advisers and fund managers. In fact, the industry has a history of delivering inferior results to investors, and its regulators do not provide effective oversight.

The companies that manage for-profit mutual funds face a fundamental conflict between producing profits for their owners and generating superior returns for their investors. In general, these companies spend lavishly on marketing campaigns, gather copious amounts of assets — and invest poorly. For decades, investors suffered below-market returns even as mutual fund management company owners enjoyed market-beating results. Profits trumped the duty to serve investors.

Mutual fund companies, retail brokers and financial advisers aggressively market funds awarded four stars and five stars by Morningstar, the Chicago-based arbiter of investment performance. But the rating system merely identifies funds that performed well in the past; it provides no help in finding future winners. Nevertheless, investors respond to industry come-ons and load up on the most “stellar” offerings......Year in and year out, flows to four-star and five-star funds prove remarkably resilient and overshadow flows to the three bottom categories.

This churning of investor portfolios hurts investor returns. First, brokers and advisers use the pointless buying and selling to increase and to justify their all-too-rich compensation. Second, the mutual fund industry uses the star-rating system to encourage performance-chasing (selling funds that performed poorly and buying funds that performed well). In other words, investors sell low and buy high.....

....Why isn’t there more of an outcry? Investors naïvely trust their brokers and advisers. Most understand too little about financial markets to make informed decisions, intervene too frequently in counterproductive ways and gather too little information about portfolio holdings to evaluate results. Investors like to believe they are doing well, even when they are not.

Meanwhile, the mutual fund industry shouts through a megaphone, making campaign contributions to influence politicians and lobbying to avoid regulation. Without any offsetting pressure from the investing public, Wall Street crushes Main Street.

What should be done? First, individual investors should take control of their financial destinies, educate themselves, avoid sales pitches and invest in a well-diversified portfolio of low-cost index funds....(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.) Second, the Securities and Exchange Commission should employ its considerable regulatory and enforcement powers to encourage individual investors to embrace low-cost index funds and shun the broker-driven churning of high-cost, actively managed funds..... Third, the S.E.C. should hold the mutual fund industry to a “fiduciary standard,” one that puts clients’ interests first.....{S}trong fiduciary standards and investor-oriented regulatory oversight would subordinate the pecuniary interests of the fund purveyors to the interests of the individual investors that the industry purports to serve......

David F. Swensen is the chief investment officer at Yale University and the author of “Unconventional Success: A Fundamental Approach to Personal Investment.”  This article was originally published in the New York Times on August 13, 2011.

Link:  The Mutual Fund Merry-Go-Round

Investment disclosure note:  While we invest most of our client's assets in ETFs, certain clients of Lumen Capital Management, LLC own legacy positions in mutual funds at the time of this article due to considerations such as tax consequences and client preferences.