Wordgems - Wealth & Economics: Baer

Mutual funds virtually force you to own bad stocks.

Every fund manager loves to see his fund grow in size -- that means a bigger bonus at the end of the year. But what's good for Fidelity, Scudder and the rest is decidedly NOT good for you.

Let's say a guy has a billion dollars to invest. He takes the first hundred million and buys the stocks that he and his team of analysts really like. But what about the rest of the money?

The market is going up. His boss is telling him to get fully invested. So he drops down a tier with the second hundred million. And then he goes down another notch with the third and so on.

Pretty soon he's sitting with a mixed bag of great stocks, mediocre stocks and more than a few "I-have-to-spend-the-money" stocks. 400–500 stocks in all for a typical fund.

What do you get? Sub-par results. In fact, over the past three years, the average growth stock fund underperformed the S&P 500 by 33%.

You can do better -- much better! We'll share proof and show you how in just a bit.

PITFALL #2

Mutual funds expose you to more risk than you know.

The allegations by the New York Attorney General point out one very real risk you take by investing in mutual funds. The industry is a world unto itself, and it's difficult -- if not impossible -- for the average person to know exactly what he, or she, is getting into.

What's more, fund managers have their own best interests -- not yours -- in mind when investing your money. It's a dog-eat-dog industry, where managers obsess about looking better than their peers.

In its mildest from, this obsession leads to things like "window dressing" -- a manager buys and sells stocks near the end of a quarter, so it looks like he's owned the best stocks all along.

At its worst, it drives managers to take bigger risks than you'd ever dream of taking with your money. Most managers have a lot of leeway and when desperate to boost their numbers will jump into derivatives, commodities and other risky ventures.

They're looking for a big burst of profits. But it seldom pans out. Do you know that approximately 80% of all mutual funds will underperform the stock market? Stick to an index fund to at least match the market.

We'll show you how to wallop the market in just a bit. And yes, even though most fund managers don't, you can. We're living proof.

PITFALL #3

Mutual fund costs are shameful.

When you buy and sell 500 stocks on a regular basis, you've got a lot of people on the payroll.

Fund manager(s); team of 25 analysts; personal assistants for everyone. Of course, they all need computers. Plus laptops. And cell phones. Health insurance. Retirement plans. Company outings. Worldwide travel.

Get the picture? Who pays for that? You!

Funds sold by brokers carry loads (commissions) of 2%-5% or more. But don't feel too giddy if you only own "no-load" funds. You'll get charged an annual management fee -- say, 1%. You pay indirectly -- off your performance -- for all the trades a fund makes (and they trade a lot). You get hit with administrative costs -- there goes another 0.5% a year.

Plus many funds sock you with 12b-1 marketing fees that run up to 1% of total assets a year. What do they use this money for? Advertisements. You're paying to help them bring more sheep to slaughter.

Is it any wonder mutual fund investors hardly ever beat the market? In just a moment, we'll show you how a happy group of 40,000 investors (and growing) have been beating the market better than 3-to-one!

PITFALL #4

Mutual funds kill you with taxes.

One man we admire in the industry is John Bogle, founder of the Vanguard Group, which pioneered low-cost index funds.

Here's what Bogle has to say about mutual funds now: "I do not believe that the mutual fund industry is giving the investor a fair shake today." One of his biggest pet peeves is the typical high turnover rate -- often 100% or more annually.

Frankly, such frenetic buying and selling just hurts performance. Plus it can blindside you with hideous tax liabilities -- even when you don't sell a single share.

Every transaction a fund makes is a taxable event. And there have been instances -- especially lately -- when investors like you have been hit with hundreds of dollars in taxes due...in a year when the value of their holdings actually fell.

We'll show you how to take back control of your investing. You'll decide when to buy and sell. You won't be subject to anyone else's whims. And you'll have more fun -- and earn bigger profits -- than you ever thought possible.

PITFALL #5

Mutual funds sharply limit your upside potential.

As we mentioned earlier, a mutual fund owning 400-500 stocks can guarantee you one thing and one thing only -- mediocrity.

What's more, you'll never realize anywhere near the full upside potential of owning great stocks.

Say, for instance, that your fund manager had purchased Marvel Enterprises -- the company behind Spider-Man -- back in July of 2002. Marvel has been on a tear since then. But you probably wouldn't have even noticed. Not with another 399 stocks bringing the average profits way down.

What's more, by charter, most fund managers are sharply limited as to how much stock they can own in any one company. Even if they love it, once they reach the limit they can't buy more! That virtually assures, once again, more mediocrity....

The Fund Fees You Don't See

While the recent mutual fund scandals raise serious questions about whom we should trust with our money, the actual dollar cost to most individual investors isn't that high. There are far more significant ways funds siphon off our dollars. And they're just as hidden.

It's simple math: The more you pay to invest, the less you'll get back in return. So-called "frictional costs" -- brokerage commissions, fees, loads, 12b-1 fees, and taxes -- leave less money to compound through the years. Which is why The Motley Fool has long recommend discount brokers and no-load, low-cost mutual funds. The problem with the latter, however, is you don't always know how much you're really paying a fund to manage your money.

This isn't news to listeners of The Motley Fool Radio Show. In an interview last November, John Bogle -- founder of the Vangard family of mutual funds -- had this to say about fund fees:

In other words, the average mutual fund has to earn 3% a year just to break even. Ouch.

Backing Bogle's assertion is a report released last month by the Zero Alpha Group, a network of independent advisory firms that promotes index investing. The study, conducted by Edward O'Neal, assistant professor of finance at the Wake Forest University Babcock Graduate School of Management, calculated the true costs of owning 30 top domestic stock funds during 2001. The results: 43% of the costs of owning a fund are not revealed by the expense ratio, the only easily accessible way to assess a fund's fees.

Funds must pay commissions to buy or sell securities, just like you and me (though they receive volume discounts). These commissions, however, are not part of the expense ratio. Nor are they usually revealed in a fund's prospectus. To find out how much a fund pays its broker -- money that comes straight out of the fund shareholders' pockets -- an investor must dig through the fund's Statement of Additional Information, which is filed with the SEC, or the semi-annual filing of form NSAR. Raise your hand if you've heard of these documents.

That's what we thought. (The two of you with raised hands can put them down now.)

Furthermore, fund families are not required to file separate documents for each fund. Rather, they can file one, big document that contains the information on many funds. According to the ZAG study, these documents can be more than 100 pages long. Have fun trying to find info on the one fund you're interested in.

On top of that, the brokerage costs disclosed in form NSAR are for all the funds that have been grouped together for filing purposes -- not broken down by individual fund -- so the figure is practically meaningless. (We must also mention that the study found that some information in the NSAR filings was suspicious. One filing reported commissions that were 10 times the size of assets under management and 16 more that disclosed commission costs that exceeded net assets in the fund.)

Then there's the question of what is really being bought with the commissions. In many cases, it's not just payment for trade executions, but also payment for other services. These so-called "soft dollar" arrangements can be used to pay for research, equipment, and even personal services, according to the ZAG study.

Commissions aren't the only costs of buying and selling stocks. Investors also have to pay "spreads."

When you see an online stock quote, chances are that's not the price you'd get if you bought this stock. That's because what you'd be looking at is usually the "bid" -- the price at which a market maker is willing to buy. What you'll pay is the "ask" -- a higher price at which a market maker is willing to sell. This spread in the prices means that investors (including mutual funds) must buy at a slightly higher price than at which they would sell. All investors face this "implicit cost," but it is magnified with a fund because it makes so many trades. However, you won't see this implicit cost listed in a fund's prospectus, either.

So how can an investor evaluate a fund's true costs? Start with evaluating expense ratios. Those are clearly stated in a fund's prospectus, on the fund's website, and in standard sources of mutual fund information such as Morningstar.com.

As for commissions and spreads, the easiest -- though inexact -- way to measure these costs is by looking at a fund's turnover, which measures trading activity. According to the ZAG study, "For high-turnover funds, the total trading costs are much higher. Together, the commissions and implicit costs are higher than the published expense ratios for each of the 10 high-turnover funds we studied. In some cases, the total costs of trading are more than double the level of the expense ratio."

A few years ago, I was discussing a specific fund with a friend, which had returned 20% the previous year. I pointed out that she was paying 2.0% a year in fees to be in this fund. Her reply was "I can afford to pay 2% to earn 20%."

That certainly sounds reasonable. After all, how much could paying an extra 1% or 2% a year hurt overall returns? Let's take a look.

Say you have the choice between two funds in your IRA. Before expenses are taken into account, both funds manage to post average annual returns of 10%. One fund takes out 0.5% in expenses, reducing its real return to 9.5%. After 20 years of depositing $250 a month in your IRA (thus reaching the current annual contribution limit of $3,000), you'd have $190,271.

The other fund, however, takes out 1.5% in expenses, reducing its real return to 8.5%. How much would you have after 20 years' worth of $250 monthly deposits? Just $167,060 -- more than $23,211 less.

OK, so that's a hypothetical example, assuming that the higher expenses don't earn you higher return. So, using Morningstar.com's Fund Screener, let's look at real life by examining the large-cap blend funds (i.e., funds that invest in both growth and value companies) that outperformed the market over the past decade.

Of the 40 large-cap blend funds that beat the S&P 500 over the past 10 years, 26 had an expense ratio less than 1.0, and only five had expense ratios that exceeded the large-cap blend average of 1.29. Only 11 of the 40 funds had turnovers above the category average of 82%. Furthermore, just seven of these funds charged any kind of load, which shows that you don't have to pay a commission to get an excellent fund.

So, the majority of large-cap funds that beat the S&P 500 have lower-than-average expense ratios and turnovers. Can the same be said of small-cap funds? Again consulting the Morningstar.com Fund Screener, only 38 small-cap blend funds beat the S&P 500 over the past 10 years. While only 12 of those funds had expense ratios below 1.0, 34 of the 38 funds had an expense ratio below the 1.57 charged by the average small-cap blend fund. As with the large-cap funds, only seven of the long-term market beaters charged a load. Also, only seven of the funds had turnover that was higher than the category average of 94%.

The more time I spend in the money management industry, the more I learn about the nearly infinite number of ways that investment firms can take advantage of their investors. All sorts of abuses result from the combination of motive -- there's big money at stake -- and opportunity. Even sophisticated investors (of which there are few) aren't aware of or can't detect certain activities.

Be extra careful when investing in hedge funds. I run one and know many great hedge fund managers (I profiled a dozen in Buffettesque Superinvestors), but there is significantly more incentive and opportunity for mischief in lightly regulated hedge funds, so make sure you really know and trust the person managing the fund.

Undisclosed Expenses and Issues (The Dirty Dozen!)
Mutual funds and variable annuities are plagued with the following ailments. SMA's (Separately Managed Accounts) also suffer under the burden of some of these expenses as well.

1. Undisclosed Brokerage Costs
The costs of trading securities are not part of the expense ratio or included in the regular prospectus, but are taken into consideration when performance information is calculated.

In some cases, according to a 2004 study done by the Zero Alpha Group, brokerage expenses actually exceed the quoted average mutual fund expense ratio. We calculate this average annual expense ratio to be 1.72%. (Calculated using Morningstar Principia software: all funds, includes stock, bond, U.S. foreign and all share classes, 8,670 funds, A, B, C etc).The Zero Alpha study implies that in a number of instances the total expenses (disclosed plus undisclosed) are in the 3-4% range.

2. Soft Dollar Payments
Payments made by a brokerage firm on behalf of a mutual fund company to cover expenses such as research, phone bills, software, computers, subscription fees and legal fees. In exchange for these payments the mutual fund company directs trades to the brokerage firm and pays a higher than normal commission. While difficult to calculate, these soft dollar arrangements which create a higher commission rate for securities trades can add an estimated 0.10 - 0.40% annually to undisclosed expenses.
Source: 2004 Investigations by New York Attorney General, Elliot Spitzer.

3. Shelf Space Payments
"Extra" marketing fees paid by funds to be included in non-transaction fee mutual fund programs offered by all major firms such as Schwab, Fidelity, Waterhouse, etc. These fees typically range from 0.20% to 0.50% annually.
Sources: Wall Street Journal, Morningstar, and Lipper.

4. Directed Brokerage
A brokerage firm agrees to sell a particular mutual fund in exchange for business directed to them by the mutual fund company. This is related to, but different from soft dollars listed above. As with soft dollars, the impact is difficult to calculate, since a higher, undisclosed commission rate for securities trades is being charged. Adds an estimated 0.10 - 0.40% annually to undisclosed expenses.
Source: 2004 Investigations by New York Attorney General, Elliot Spitzer.

5. Boards That Do Not Represent The Shareholder
The vast majority of mutual fund boards are hand selected via a "good ole boys" network. The board chairman is usually not independent. The majority of mutual fund board members don't own any of the funds they are responsible for.
Source: Morningstar

6. Ever Increasing Fees
While fund expenses had been predicted over a decade ago to slowly decline as assets increased, the opposite has taken place due to ever increasing and poorly disclosed expenses such as 12b-1 marketing fees.

8. Survivorship Bias
The performance rankings of mutual funds do not contain the past track records of funds that have been closed, merged, had a name change, etc. Many of the funds that undergo such changes have been poor performers.
For the 10 years that ended in 2003, a 2004 study by the Center for Research in Security Prices at the University of Chicago shows that if these "missing" funds were included, the average performance of U.S. equity funds would be 1.6% less per year than typically reported, making the performance for the average investor in U.S. equity mutual funds as compared to the S & P 500 index even worse. The study calculated an average annual gain of 8.8 percent using only surviving

U.S.

stock funds, and 7.2 percent counting funds that no longer exist. Listed below is a comparison for the ten year time period ending 12/31/03:

9. Tax Drag
According to Lipper, the average equity mutual fund loses approximately 1.96% annually to taxes as a result of fund distributions that are subject to tax. In many cases, fund shareholders are paying taxes on stocks that were bought years before they entered the fund, but due to fund shareholder accounting they are required to pay tax on a gain they never earned.
Source: Lipper's "Taxes in the Mutual Fund Industry - 2004"

10. No Price Advantage For Larger Accounts
Mutual funds have a fixed pricing structure, which charges all shareholders the same annual expenses ratio, regardless of account size. An investor with $1,000,000 is charged the same rate as the investor with $1,000.

11. Share Class Confusion and Shenanigans
With "A", "B", "C", "R" "Q" "Z", etc. how is an investor to know if they are being sold the best share class. Multi-million dollar settlements have been extracted from a number of brokerage firms for allowing their brokers (salespeople) to maximize commissions at the expense of the customer by spreading the client's money across various fund companies and /or share classes.

12. Manager Tenure & Experience
The average tenure of a mutual fund manager is 4-5 years, with many fund managers having little experience at managing a mutual fund.
Source: Morningstar Principia software.

Summary Commentary on the "Dirty Dozen"

Expenses + Taxes
The challenge of undisclosed fund expenses is you simply cannot obtain the information to come up with an exact number. That said, we estimate the total costs of fund ownership for the average mutual fund investor to be 1.8% -5.0% annually, depending upon the investment, purchase arrangement and taxes. We have prepared a detailed cost comparison on the following page.
Expenses + Taxes + Survivorship Bias + Sales Loads + Negative Investor Behavior Survivorship bias and the Dalbar information shows that worse than the mutual funds themselves, the average investor creates even more damage than any other single element. A skilled professional advisor can help minimize such losses.

Summary
Some combination of the above The Dirty Dozen does impact every mutual fund investor every year. In the end, we expect that the typical fund investor, left to their own self directed mistakes, the products sold by commission based financial advisors and the general undisclosed expense ills we have outlined creates a situation where over a ten year period of time if the expected gross return was 10% for the stock market we suspect that the average fund, variable annuity or broker advised investor may achieve as little as 3-4% per year in the best case scenarios and many would simple have been better off leaving the money in their checking account.