When I recently left my job of several years, I took great delight in having the opportunity to roll over my 401(k) into an IRA account with my discount broker. The administrator of my old 401(k) only offered a small basket of mutual funds, ranging from a money-market fund to bond, stock, and alternative investment funds. As an IRA with my broker, my money is now freed from this limited range of choices – I am now able to invest in individual stocks and bonds and use options to hedge risk as I do with my regular brokerage account.
But choice is not the real reason I left the world of mutual funds or why I am urging others to explore it for themselves. After all, with my retirement money now at a broker of my choosing, I could have invested with a much broader range of mutual funds than the small basket on offer from my former 401(k) administrator.
Choice only really matters to those investors who are willing and able to put the time into making their own investment decisions. For many people, choice is a headache. They’d much rather just pay a fee and “own the market.” But what a lot of people don’t understand is that, too often, you don’t really own the market – you own a fund manager’s idea of the market, and, well, some managers are better than others. Also, there are relatively few products out there that even aspire to own the market. Most mutual funds are themed – Large Cap, International, Intermediate Bonds, etc. So even within the scope of less choice, you can still choose awfully wrong, and it can have a material impact on your retirement account.
This begins to hint at why mutual funds are a bad investment for many folks. Whether aspiring to own the market or to play a niche, most mutual funds simply don’t deliver results. At the beginning of the 2012, Barry Ritholtz summarized the recent plight of mutual fund managers, writing:
“Data from Morningstar shows that among 4,100 funds that invest in large-cap stocks, only 17% beat the SPX. That is the smallest percentage since 1997 beating their benchmark – the S&P 500 – since 1997, when 12% beat the SPX. If we look at the percentage of funds under-performing by 250 basis, it’s the worst since 1998.”
Here in the third quarter of 2012, it looks like we are seeing a repeat performance from mutual funds this year. The overwhelming majority of mutual funds have underperformed the S&P 500 once again. The obvious question…why on earth would I pay a fund manager to underperform the market? After all, I can do that myself for free.
Results Aren’t the Only Problem
More than being just a club of underperformers, mutual funds also open a small window onto the financial world, and increasingly, people don’t like what they see. Just today, there are two unrelated stories in the Wall Street Journal that demonstrate that mutual funds are as rotten as the rest of Wall Street and require a closer look from regulators and Congress.
The first story concerns the recent initial public offering of Facebook. As many folks know, Facebook’s stock value has been cut in half since it went public, saddling many retail investors with huge losses. The lead underwriter on the IPO was investment bank Morgan Stanley. The bank has been blasted by many financial commentators for green-lighting the $38 per share IPO price, such that many research departments on Wall Street were calling the stock overvalued at the time of its debut, setting up the cascading downward pressure on shares. This mistake was bad enough, but the Wall Street Journal now reports that Morgan Stanley-run mutual funds have “disproportionately high investments in the social-media company, leaving fund shareholders exposed to the stock’s big drop since its May 18 IPO.”
What’s wrong with that, you might ask?
Fund managers have a fiduciary duty to their investors to maximize investment gains and minimize losses. What if it were possible to prove that MS-run mutual funds purchased Facebook shares on some other grounds, like a desire to prop up the value of the stock? Does it not illustrate perfectly the conflicts of interest inherent in today’s financial supermarket model?
Today on CNBC’s Closing Bell, this possible breach of fiduciary duty was explored in a very smart segment. One gentleman, a finance professor at the University of Florida, argued that the MS mutual funds had to know that its purchases were too small a percentage of the overall float to move the price; therefore, he reasons that price manipulation was not the purpose of the share purchases. And yet, Morgan Stanley’s mutual funds rushed into the burning building when the rest of the Street stayed away. The WSJ article explains:
“New data show that eight of the top nine U.S. mutual funds with Facebook shares as a percentage of total assets are run by Morgan Stanley’s asset-management arm, according to fund tracker Morningstar Inc.”
There really is no rational explanation for this. Any fund manager who would ride a 50% decline in a position is an imbecile. While it is true that the cost basis for the funds’ Facebook investment was probably not the IPO price of $38 per share, I doubt very much that it was $20 either. It’s almost a certainty that these funds have lost money on Facebook, potentially lots of money. It leads one to question the independence of the fund managers involved in Morgan Stanley’s mutual funds, and it especially shines a bright light on why the notion of “Chinese walls” between a large bank’s various units is hogwash. Given the involvement of large banks in mutual funds – and the way these funds are marketed to the retail investor – the notion that fund managers have their clients’ interests top of mind is highly debatable and provides yet another reason why investors should re-examine holding mutual funds.
Breaking the Buck
The second Wall Street Journal article of note this morning concerns the money-market fund industry. While most people view money-market funds as highly liquid financial instruments akin to a savings account, in reality they are just mutual funds with high safety profiles. But as the financial crisis showed, even these ultra-safe instruments are not so safe in times of great market upheaval, and because of the corporate debt – including bank debt – that money-market funds held back in 2008, some funds found themselves unable to make investors whole, particularly when investors showed up in large numbers to withdraw their funds. The sum result was panic in the last place anyone would have guessed.
The Securities and Exchange Commission recently tried to tackle this issue, but as with most things these days, they failed. Thanks to a former mutual fund industry leader who now sits on the Commission, Chairman Mary Schapiro’s proposal to beef up regulation was voted down 3 to 2. The WSJ explains her recommendations:
“Despite 2010 rule changes that made funds more resilient to shareholder redemptions, Ms. Schapiro said more should be done to protect the industry. Her proposal included rules to force funds to set aside capital to absorb sudden losses in the value of the asset holdings and to hold back a small portion of investor cash when they redeem all their shares at once, to reduce a customer stampede. She also wanted to require money-fund share prices to float like other mutual funds.”
Opponents of the proposed rules included, guess who, the mutual fund industry, who contended that the new rules would render these products unusable and drive business to lesser regulated corners of the financial industry. But I would argue that what makes these products “unusable” is the fact that they are not what the fund managers claim they are. What good is a highly stable, super-safe fund if the fund is apt to lose value in a crisis? After all, there is no reason to invest in a zero-return investment other than safety, and the only time safety becomes important is during a crisis, the very period these funds failed to live up to their billing.
Have you ever marveled at how money-market funds always (excepting the dark days of 2008) have a net asset value of $1? Well, you, too, could accomplish the same feat if the federal government allowed you to dispense with standard accounting practices. An opinion piece from the WSJ explains:
“SEC rules have long allowed money-fund operators to employ an accounting fiction that makes their funds appear safer than they are. Instead of share prices that fluctuate, like other kinds of securities, money funds are allowed to report to customers a fixed net asset value (NAV) of $1 per share—even if that's not exactly true.
“As long as the value of a fund's underlying assets doesn't stray too far from that magical figure, fund sponsors can present a picture of stability to customers. Money funds are often seen as competitors to bank accounts and now hold $1.6 trillion in assets.”
It is clear from the SEC’s failure to remedy the money-market problem that the industry controls the very agency that was meant to regulate it, much as the Wall Street Journal claims. Yet another reason to stay away from mutual funds, even these so-called “safe” funds.
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