Don’t Get Ripped Off by the Mutual Funds

I was reviewing the portfolio of a new Concierge member yesterday and was horrified by what I found. After following me for several years, his single stock picks were mostly mine and doing great. But he had WAY too many mutual funds.

How many mutual funds would you guess outperformed the stock market since the bull run started 14 years ago?

If you guessed 1,000, 100, or even 10, you would be dead wrong, and even off by miles. In actual fact, not a single mutual fund has beaten the market since 2009.

Remember all those expensive, slickly produced TV ads boasting market-beating ratings and top quartiles?

You know, the ones that show an incredibly good-looking but aging couple walking hand in hand into the sunset on a deserted beach?

They are all just so much bunk. The funds mentioned rarely quote performance beyond one or two short years.

Like my college math professor used to tell me, “Statistics are like a bikini bathing suit. What they reveal is fascinating, but what they conceal is essential.”

Recently, the New York Times studied the performance of 2,862 actively managed domestic stock mutual funds since 2009. It carried out a simple quantitative analysis, looking at how many managers stayed in the top performance quartile every year.

Their final conclusion: zero.

It gets worse.

It is very rare for a manager to stay in the top quartile for more than one year. All too often, last year’s hero is this year’s goat, usually because they made some extreme one-sided bets that turned out to be a flash in the pan.

The harsh lesson here is that investing with your foot on the gas pedal going 100 miles per hour and your eyes on the rear-view mirror is certain to get you into a fatal crash.

The Times did uncover two funds that stayed at the top for an impressive five years. They turned out to be small cap energy funds that took inordinate amounts of risk to achieve these numbers and have since lost most of their money.

I guess they didn’t read the Diary of a Mad Hedge Fund Trader’s warning of a potential oil crash if we ever got a peace deal in Russia.

The reasons for the woeful underperformance are legion. Management fees are sky-high and grasping. Hidden costs are everywhere. Read the fine print in the prospectus, as I do, and you would be shocked, shocked like they had gambling in the casino.

Real talent is in short supply in the mutual fund industry, with all the real brains decamping to start their own 2%/20% hedge funds. The inside joke among hedge fund managers is that employment at a mutual fund is proof positive that you are a lousy manager.

Let’s go back to those glitzy TV ads, which cost millions to produce. If you are a mutual fund investor, you are paying for all of those too. They are made at the expense of a lower return on investment on your money.

And those sexy performance numbers? They benefit from a huge survivor bias. As soon as fund performance starts to tank, the managers close it, lest it pollutes the numbers of other funds in the same family.

The number of funds with good, honest 20-year records can almost be counted on one hand.

Now let me depress you even more.

An industry performance this poor underperforms random chance. That means chimpanzees throwing darts at the stock pages of the Wall Street Journal would generate a higher investment return than the entire mutual fund industry combined.

So much for all of those Harvard MBAs!

Are you ready to throw your empty beer can at the TV set yet?

If you think all of this stuff should be illegal, you are probably right. But since you watch TV, then you have probably been trained like a barking seal to oppose the regulation that would reign these people in.

This is what the attempt to kill the Dodd-Frank financial regulation bill was all about. The mutual fund industry complains bitterly that they are over-regulated and spend millions on lobbyists to get themselves off the hook. By the way, these expenses also come out of your fund performance.

These are all reasons why the Mad Hedge Fund Trader is able to generate such high-performance numbers year in and year out.

I am not charging you with any of my overhead. I am not jacking up your commissions. My annual trips on the Queen Mary II are totally at my expense. Nor am I selling your order flow to high frequency traders for a tidy sum, so they can front-run you. I don’t even sell your email address to another online marketer.

Being a small operation of 15 or so people, I’ll tell you what I don’t have. I lack an investment banking department telling me I have to recommend a stock so we can get the management of their next stock issue or a sweet M&A deal and reap huge fees.

I am absent from a trading desk telling me I have to move this block of stock before the prices drop and my bonus gets cut.

And I am completely missing a boss screaming at me that if I don’t get my orders up, my wife would have to become a prostitute to support our family (yes, some unsympathetic sales manager actually told me that once. I later heard he died of a heart attack at 36).

You just need to pay me a low, flat, annual fee, and I’m done. I don’t need any more. It’s up to you to search out the best deal you can get on executions.

Don’t even think about trying to give me your money to manage. I don’t want it. It is too late in life for me to be regulated.

This is why the overwhelming bulk of investors are better off investing in the cheapest Vanguard index fund they can find, diversifying holdings among a small number of major asset classes, and then rebalancing once a year (click here for my “Buy and Forget Portfolio” ).

Welcome to the brave new world.

 

But We’re In the Top Quartile!