Mutual Funds (posted 10 Mar 99)

Mutual funds have been one of the great success stories of the bull market that started in the early 1980s. Their professional management of large pools of capital appears to offer small individual investors some of the key advantages enjoyed by large institutional investors: a spread of investments to reduce risk; and reduced dealing costs. Certainly, small investors who buy stocks directly have historically faced much higher trading costs because they could not match pooled funds' ability to negotiate lower commissions from brokers. Nor do such investors typically have the size of assets to achieve effective diversification.

There are a number of ways of categorizing funds, for example, open-end versus closed end and load versus no-load. Open-end funds (or unit trusts, as they are known in the UK) will sell as many shares as investors want but the shares cannot be traded on a secondary market; closed end funds (investment trusts in the UK) issue only a limited number of shares but they can be traded. Load funds charge a commission when they are bought and sold; while no-load funds only charge a management fee. Funds can also be distinguished by their investing style - notably active versus passive; and value versus growth - and by the asset class in which they invest - bonds versus stocks versus money markets versus everything else; and within stocks, large cap versus small cap.

The wide selection of mutual funds now available allows individual investors to get exposure to many more asset classes, geographical markets and investment styles than was possible in the past (see, for example, EMERGING MARKETS, FIXED INCOME, GLOBAL INVESTING, GROWTH INVESTING and VALUE INVESTING). But at the same time, because there are so many funds, it has become very difficult to choose between them. (Indeed, in some countries, there are more funds than there are listed stocks.) An entire industry has grown up to support the mutual fund business, providing information and apparently helping investors evaluate funds. Fund consumers in the United States - and increasingly elsewhere - now have access to enormous amounts of data about their investments.

Fund rating is usually done on the basis of past performance, past volatility and expenses (though some rating agencies try to be more forward-looking and offer explicit recommendations). Morningstar, for example, which rates all mutual funds, awards between one and five stars based on a mechanical formula. These stars are not recommendations, but they are naturally used as marketing tools, and floods of money go into funds that have five stars on the assumption that those that have done well in the past will continue to do so in the future.

Mutual funds guru: John Bogle

Jack Bogle has a heart... for investors. He has earned the reputation, almost unique among heads of mutual fund complexes, for unstinting dedication to the interests of fund investors. He promotes low costs and skepticism about investment management skills, regularly taking public positions on such traditional unmentionables as financial services compensation. And he takes his own medicine with the lowest cost structure in the industry, comparatively modest salaries and a reputation for being his own harshest critic.

Jack Bogle has a heart... a new one. After years with a severely damaged heart, he continued active work while awaiting news of a transplant. Right beside the fibrolator in his office required for the periodic heart failures, he kept a squash racket as a reminder of the tough, competitive life he longed to lead. Finally, a new heart was put in - and in what must have been the shortest recuperation on record, he was back again. This time, his board of directors insisted he take the title of senior chairman. He agreed on the condition that he would come to the office every day and remain active in Vanguard, his company... although nominally it is a mutual owned by the fund shareholders.

The history of Vanguard and Jack Bogle's role in founding it may have formed the basis for many of his ideas. In the 1960s, he was the likely young successor to the head of Wellington Funds in Philadelphia. Surprisingly, the owner sold the company to a fledgling Boston firm run by four equally young Turks, who wanted to move the entire company to one location - theirs. A compromise was reached, perhaps grudgingly, to move the investment operations to Boston, with the new owners thinking that they were about the only thing that counted. The operations and sales end of Wellington stayed in Philadelphia as a mutual structure since, according to the understanding of the day, there was nothing of value there.

But there was. Wellington in Philadelphia under Jack Bogle's direction was closest to the mutual fund shareholder. Wellington in Boston, combined with Thorndike, Doran, Paine and Lewis, emphasized the then more attractive institutional business. There was an uneasy truce between the two places, and today the split is almost complete. Jack Bogle's single-minded endorsement of mutual fund shareholder concerns and an unresolved beginning partnership planted the seeds for the need for a truce.

Bogle has been a great advocate of mutual funds but he is skeptical about the ability of mutual fund managers to 'beat the market': In a speech to the 'Money Show' in early 1999, he argued: 'The one great secret of investment success is that there is no secret. My judgment and my long experience have persuaded me that complex investment strategies are, finally, doomed to failure. Investment success, it turns out, lies in simplicity as basic as the virtues of thrift, independence of thought, financial discipline, realistic expectations and common sense.'

'What does the past tell us about the complex investment strategies that entail selecting winning mutual funds?', Bogle asked. 'Over and over again, it sends the same message: don't go there. (Why? Because using Gertrude Stein's inspired phrase, 'there is no there there'.) No matter where we look, the message of history is clear. Selecting funds that will significantly exceed market returns, a search in which hope springs eternal and in which past performance has proven of virtually no predictive value, is a loser's game.'

Bogle urges mutual fund investors to rely on simplicity and encourages them to set a simple standard as their objective: 'The realistic epitome of investment success is to realize the highest possible portion of the market returns earned in the financial asset class in which you invest - the stock market, the bond market or the money market - recognizing and accepting that that portion will be less than 100%.'

To accomplish this objective, Bogle recommends an index fund investing in the entire stock market, which is 'diversified across almost every publicly held corporation in America; essentially untouched by human hands; nearly bereft of costly portfolio turnover; remarkably cost-efficient; and extraordinarily tax-effective. Such a fund will provide you with - indeed, virtually guarantee you - 98-99% of the market's annual return over time, a vast improvement over the 85% or so that the typical mutual fund has provided.'

Counterpoint

There are studies suggesting that some mutual fund managers may have a 'hot hand' and that past mutual fund returns can dependably predict future returns. Princeton finance professor Burton Malkiel, who is also a director of Vanguard, is not persuaded by this work, which seems to indicate that you can pick mutual funds on the basis of their past performance (see MARKET EFFICIENCY). In the seventh edition of his classic book A Random Walk Down Wall Street, he points out the problems and some of the questionable practices of mutual fund complexes and fund rating agencies:

'I am convinced that many studies have been flawed by the phenomenon of 'survivorship bias', that is, including in their studies only the successful funds that survived over a long period of time, while excluding from the analysis all the unsuccessful funds that fell by the wayside. Commonly used data sets of mutual fund returns, such as those available from the Morningstar service, typically show the past records of all funds currently in existence. Clearly, today's investors are not interested in the records of funds that no longer exist. This creates the possibility of significant biases in the returns figures calculated from most of the available data sets.'

'Mutual funds that are unsuccessful with big risky bets usually do not survive. You are not alone in being reluctant to buy a mutual fund with a poor record. Mutual fund complexes typically allow such a fund to suffer a painless death by merging it into a more successful fund in the complex, thereby burying the bad fund's record. Thus, there will be a tendency for only the more successful funds to survive, and measures of the returns of such funds will tend to overstate the success of mutual fund management. Moreover, it may appear that high returns will tend to persist because funds whose bets were unsuccessful will tend to drop out of the sample.'

'Another little known factor in the behavior of mutual fund management companies also leads to the conclusion that survivorship bias may be quite severe. A number of mutual fund management complexes employ the practice of starting 'incubator' funds. A complex may start ten small new equity funds with different in-house managers and wait to see which ones are successful. Suppose after a few years only three funds produce total returns better than the broad market averages. The complex begins to market those successful funds aggressively dropping the other seven and burying their records. The full records from inception of the successful funds will be the only ones to appear in the usual publications of mutual fund returns.'

Malkiel has examined more than twenty years of data on the records of all mutual funds that were available to the public each year, whether or not they survived into the 1990s. His analysis of these mutual funds returns confirms his view that securities markets are remarkably efficient, and that, as Bogle suggests, most investors would be considerably better off purchasing a low expense index fund than trying to select an active fund manager who appears to have a 'hot hand'.

The practice of launching many funds and subsequently dropping the losers explains the common question of company treasurers: why is it that everyone who comes to call on me has better than market performance but my managers are just scattered around average? But the real answer is that it is only worthwhile selling what the market will buy. A clever strategy for a fund complex might be to have widely diversified portfolios with extremely low correlations to the market averages but quite different from one another. This 'dumb-bell' strategy almost guarantees that some will be performance disasters but a few will be big enough winners to attract attention. No one seems to follow the strategy but it would work.

One reason you can be far from confident that a stellar performer will continue to outperform the market is that outperformance naturally attracts a lot more cash to be invested in the funds. As funds become larger with success, it becomes more difficult to sustain excellent performance: the universe of securities that are realistically available shrinks. Another reason is that transactions costs increase with size: although big institutions can trade at relatively low commissions, shifting substantial blocks of securities tends to move market prices.

Jason Zweig, mutual funds columnist of Money Magazine, describes the problem of outperformance and excessive size well in a contribution to Peter Bernstein's newsletter Economics and Portfolio Strategy: 'Here, then, is one of the harshest truths of the information age: cash flow from clients now rivals the investment process itself as the main determinant of total return. Thousands of retail investors, each wielding only a few thousand dollars, can smother a fund manager with cash as soon as they detect what appears to be outperformance. Alpha has always been perishable, but in today's world of instantaneous information it is likely to have the shelf life of unrefrigerated fish. When a fund manager goes from absorbing a trickle of cash flow to drinking from a fire hose to surfing a tsunami, his past performance loses all relevance.'

But despite the problems Bogle and Malkiel identify with actively managed mutual funds, is indexing an appropriate response? Funds that follow a strategy of hugging the benchmark almost guarantee that they will neither lose nor win on performance, but they will require major sales efforts to distinguish themselves from the pack. And funds in the United States must be at least 90% committed to securities, limiting the asset allocation objective of diversification between assets and cash, and hence making themselves vulnerable to falling markets.

What is more, the funds must typically be in easily priced assets, and primarily in national rather than international assets, objectives that may be fine in a bull market but not so desirable when things turn bearish (see INDEXING). Particularly for closed end funds, there could be a severe liquidity problem if a large number of investors decide to liquidate their holdings: to whom will they sell? And might there be more interest in 'guarantees' when the market goes down? In the United States at least, a substantial percentage of investors think their funds are like savings accounts, guaranteed by the US government.

Finally, there is a peculiarity of fund accounting that open-end funds are bought and sold at net asset value plus a commission. Accounting for net asset value is the sum of all the market or appraised value, unadjusted for capital appreciation or depreciation. Thus an investor purchasing a fund with large unrealized capital appreciation may find when these issues are sold by the fund that he or she has a large tax bill for appreciation that occurred during another investor's holding period. There is a good suggestion that GAAP (generally agreed accounting principles) should apply a reserve for taxes to be paid for funds as it would for a corporation, but the fund industry is against it.

Where next?

In the past forty years or so, investment products have gone from being bought by investors, usually on the basis of word-of-mouth, to being sold by intensive and expensive marketing programs. Is this necessarily the best development? Today, information on investment products can be disseminated effectively through the internet but, at the moment, we are barraged by rather simplistic publicity campaigns, often just a repeat of regular published paper information. We have not yet started using the informed comparison capability of the internet and perhaps this will not happen until after the next bear market. Investment marketing needs to be shaken up a great deal.

Discussing marketing of mutual funds in relation to their investments in internet stocks, James Cramer of theStreet.com comments: 'Mutual funds have about the worst truth-in-labeling problem I have come across in any industry. I think there should be a rule: the term value should not get applied to firms that own such high-multiple stocks. Value in this world has simply become a masquerade, a mean-spirited marketing tactic that lures people in the door who would otherwise have no desire to own such nosebleed stocks. You will never get the SEC to bring a case against a growth manager who has hidden behind the 'value' nameplate. That would be too broad. But these big mutual fund families have a responsibility to market their products responsibly.'

Cramer's comment might be referring, among others, to Bill Miller's Legg Mason Value Trust questioning the appropriateness of a 'value trust' that owns twenty-five hot technology stocks out of a portfolio of thirty. Miller would defend such a position by saying it is 'value tomorrow' (see ACTIVE PORTFOLIO MANAGEMENT).

And what about the cost of financial services? Abby Cohen of Goldman Sachs points out that the only form of compensation that is going up is for financial services, and it is going straight up. We might have expected exactly the reverse - that the use of machines would drive costs down, and that performance measurement would make buyers realize that you could operate at lower cost and actually have better results. But this has not happened, and in the midst of a bull market, costs are going up. There is this huge system eating away at returns with costs that are at least 0.5% of assets a year and probably more. And of the proportion of assets that are actively managed, it may be as much as 10% by the time you take away the closet indexing.

Finally, some possible future developments for the mutual fund business:

· Customized portfolios: investors might be able to build their own 'fund of funds' with tools provided by the fund complex.

· Easier switching from fund to fund within the same complex: rather like Fidelity sector funds with low or no switching costs except for the double taxation - an investor selling a fund at a gain pays taxes on the gain but another investor also pays when the fund makes a capital gain distribution on the gain that went to the selling investor.

· Funds could maintain live bulletin boards of information, a live FAQ (frequently asked questions) for marketing purposes. Currently, these answers have to be cleared legally, which slows the process.

· Fund regulation around the world could be made standard through IOSCO, the International Organization of Security Commissioners and Officers.

Read on

In print

John Bogle, Bogle on Mutual Funds: New Perspectives for the Intelligent Investor
John Bogle, Common Sense on Mutual Funds: New Imperatives for the Intelligent Investor
Paul Farrell, Mutual Funds on the Net
Bill Griffith, The Mutual Fund Masters
Burton Malkiel, A Random Walk Down Wall Street

Online

www.brill.com - website with extensive information on mutual funds
www.iii.co.uk/performance - website with investment performance details for UK funds
www.morningstar.com - the Morningstar website
www.thestreet.com - James Cramer's online financial publication
www.vanguard.com - website of the Vanguard Group