Co-founder of @AuroraSignals, quant hedge fund co-manager, financial advisor, entrepreneur, trader of equities | forex | options
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Thu 11 December 2014

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Mutual funds: the good, the bad, the ugly

These highly popular investment vehicles may be costlier than you think, and it's not just because of the fees.


There's a reason “loaded” mutual funds are on track in 2014 to post highest redemptions in at last 21 years. In fact, Morningstar estimates over the first 10 months of this year, outflows have totaled $122 billion.

"If that figure holds, it could be the worst year ever for that share class, topping the nearly $88 billion in redemptions during 2011. Morningstar started tracking the data in 1993." -Trevor Hunnicutt

Source: Investment News

If you are invested in the market, or have someone in your family that is, chances are a portion (or all) of that investment is in mutual funds. In fact, according to the Investment Company Factbook, about half of all U.S. households own mutual funds. The primary reasons for this are their ease of use, "simplistic" structure, and marketability to the masses. Think "turn key" investment when you hear mutual fund, but also ask yourself what are you giving up for this convenience? For those unfamiliar with what exactly a mutual fund is, below is a simple infographic explanation.

MutualFund1

Source:mint.com

Transparency is information; information is money.

In my experience as an advisor, I've come to learn just how much people care about transparency. Some claim it matters little to them, but when you're investing money you've worked hard to earn, chances are you would like to know how it's being put to work and why it's invested the way it is.

The more you understand about your investments, the more equipped you are to make better decisions going into the future. In this case, such information may help you save a good bit of money. Span those savings over multiple decades; compound the returns, and you're left with a surprising number in the end.

Time is a commodity, thus, time is money.

This isn't just about fees, though, there's more to it than that. The time you have to invest is limited, as with anything in life. Time is a constraint on all people, so in terms of investing, it should be viewed as a commodity. Just because a certain approach, or investment vehicle, has "worked" well in recent years doesn't mean: (a) that it will continue to do so, and (b) that it is the best method or use of time and capital. Between the time one begins saving for retirement and the day they retire (and into perpetuity), they should seek to optimize that finite period. It is difficult to argue that one single method is the absolute best, compared to other options, but the real focus should be on making the best decision with the given amount of information you have. When it comes to investing, information can be very powerful, and the more of it you have, the more options you have. You should always seek options that give greater transparency, and thus, greater information. Keep this point in mind.

The good.

  • Ease of use.
  • Wide range of offerings.

Mutual funds are about as easy as it gets when it comes to investing. Mutual fund companies try and streamline the investment process as best as possible, and for the most part they do a fine job. To put into perspective their popularity, take a look below at the number of individual investors and amount of assets the industry has.

MutualFund2

MutualFund3

Source:mint.com

I would say the greatest qualities of mutual funds are their ease of investing and the "diversification options" they provide. Know I say "diversification options" in a somewhat tongue in cheek manner. An investor has the ability to diversify fairly well through mutual funds but to do so they need (what I would consider) above-average investment knowledge and a good understanding of asset correlations and causations. Unfortunately, this skillset doesn't apply to most mutual fund owners. A false understanding of diversification can be just as damaging to a portfolio than a complete lack of it to begin with. Understand that many "diversified" portfolios (i.e. ones holding many different mutual funds) were down in 2008-09 just as much, or more, as portfolios constructed with little to no thought given to diversification.

The bad.

  • Can provide a false sense of effective diversification.
  • Can lead to under- or non-management of a portfolio.
  • No intraday liquidity

Diversification:

The issue with certain investment products like mutual funds is they can, as mentioned before, create a false sense of security. Often, investors construct mutual fund portfolios based on a certain risk tolerance allocation (of stocks, bonds, cash, etc.) and then leave them for extended periods of time. This occurs frequently because mutual funds and similar products are designed to be off-the-shelf products with low maintenance. Particularly in today's markets, due to unprecedented monetary policies in effect, proper portfolio diversification is extremely important. Being in 3, or 53, mutual funds does not guarantee proper portfolio diversification. For a deeper understanding of this prevalent issue, see my article on diversification.

Management:

The issue with "low-maintenance" products is they sometimes become "no-maintenance" products over time. Unless you're an avid value-investor with investment hold periods of 5-10+ years, a low- or no-maintenance approach can be costing you precious time and money over several decades. Remember, your investment time-period is limited, be efficient with it. This doesn't mean your advisor (or you) must monitor or adjust positions daily, or even weekly, but in today's market climate, a well and actively managed portfolio can produce above-average results with lower risk (of course, much of this depends on the specific portfolio management practices).

Liquidity:

This is a constraint on mutual funds that is rarely known or discussed. What does it mean? Mutual funds only trade at the end of the day because you trade mutual funds based on their net asset value (NAV). To determine the NAV at the end of the trading day, the mutual fund company looks at all of the assets that are in the basket, determines their value and divides that number by the total number of outstanding shares in the fund. Ultimately, if you have mutual funds in your portfolio that you need liquidated immediately (perhaps due to an imminent systemic risk in the market), you're stuck in them through to the end of the day. There have certainly been instances in the last decade where being able to liquidate a position instantaneously (which you can with most traded stocks and ETFs) has been a good option to have. Some would argue that due to the "long-term hold" nature of mutual funds, this issue shouldn't matter--but again, being "locked" into something without a choice can expose you to unnecessary risks.

The ugly.

  • No real ability to know exactly how a specific fund is being managed: added layer of investment uncertainty.
  • Frequently they underperform their benchmarks.
  • High average fees, often inefficient tax consequences.
  • Hidden costs pertaining to above mentioned inefficient market transactions.
  • Institutional fund managers generally rebalance using ad hoc methods such as calendar basis or tolerance band triggers.

Management transparency:

Yes, actively managed funds have managers with stated objectives--but the objective is typically all you have to go by. According to the SEC investment company mandate, mutual funds are only required to publicly report their total holdings semiannually. Some funds voluntarily report their holdings on a more frequently basis, such as quarterly, but any reportings data is delayed by 30 days or more. Concerns have been raised over the years regarding the transparency of mutual funds and the practices of their managers:

Petitioners also argue that more frequent disclosure would help to shed light on and prevent several potential forms of portfolio manipulation, such as "window dressing" (buying or selling portfolio securities shortly before the date as of which a fund's holdings are publicly disclosed, in order to convey an impression that the manager has been investing in companies that have had exceptional performance during the reporting period) and "portfolio pumping" (buying shares of stock the fund already owns on the last day of the reporting period, in order to drive up the price of the stocks and inflate the fund's performance results).
Source: Securities and Exchange Commission

Remember, for advisors, investment managers, and individuals, the more layers of uncertainty one can remove from the investment process, the better.

Performance:

The newest S&P Indices Versus Active Fund report (SPIVA) report is yet another piece of evidence showing that mutual funds have a tendency to underperform their benchmark. What does this mean? As mentioned before, every mutual fund has an objective, whether it is a specific strategy, or to mimic a broad market index (i.e. the Dow Jones). In order to "grade" the performance of that fund (monthly, annually, 3, 5+ years), managers use a benchmark index that they seek to match or beat. This approach, arguably flawed, is used to allow investors to see if the manager is providing them with added value for the fees they pay. In other words, are investors getting better performance by being invested with that manager vs. investing directly into that benchmark index on their own (avoiding the various fees) or by going with another strategy altogether. Below is the data reported from the 2014 SPIVA report:

  • For the 12-month period ending June 30, 2014, 60% of large-cap mutual fund managers, 58% of mid-cap mutual fund managers and 73% of small-cap mutual fund managers underperformed their benchmarks.

  • As we lengthen the time horizon, underperformance strongly tends to increase. While 60% of large-cap active managers underperformed over the prior 12 months, 85% underperformed over the prior 36 months and 87% did so over the prior 60 months.

  • Note that all of the figures cited are based on pretax returns. Given that the higher turnover of actively managed funds generally makes them less tax-efficient, on an after-tax basis the failure rates would likely be much higher because taxes are the largest expense for actively managed funds.

Source: "Here's the latest failing grade for active funds"

Visible costs:

As seen in the table below, research shows equity mutual fund investors pay an average of 2.67% in annual fees, with an additional average 1.10% in embedded tax liabilities (See cost break-down). These costs come from the following: management fee, commissions, non-management fee, marketing fee (12b-1 fee), sales load (front or back end loads), and the redemption fee. While they vary from fund to fund (some don't have sales loads, others wave commissions, actively managed funds have higher expenses vs. index funds, etc.), these are the typical fees one may expect when investing in a mutual fund.

MutualFundFee

Invisible costs:

In addition to the “visible” costs, researchers from University of California Davis, University of Virginia, and Virginia Tech found mutual funds also incur a host of “invisible” costs that are less transparent to investors—most notably, transaction costs. They found that equity mutual funds’ annual expenditures on trading costs accounted for, on average, an additional 1.42% in “invisible” costs. While the exact number varies for every mutual fund, one should seek to avoid these potentially costly expenses.

Source: "Shedding Light on 'Invisible' Costs: Trading Costs and Mutual Fund Performance"

Rebalance methods:

Institutional fund managers generally rebalance using ad hoc methods such as calendar basis or tolerance band triggers. What does this mean exactly? When determining when to adjust a position size in the fund, managers typically use methods (arguably arbitrary methods) that are more based on a set of rules rather than market events. For instance, most fund managers rebalance their positions on a quarterly or semi-annual basis--primarily because that is how it has traditionally been done, and is convenient in terms of reporting periods. The issue with this common method is it really doesn't take into account what the market is doing. More effective rebalance methods are (and should be) event-based, taking into account changes in the market, not the calendar--the calendar gives no regard to what the market is doing.

Conventional approaches to portfolio rebalancing include periodic and tolerance band rebalancing. With periodic rebalancing, the portfolio manager adjusts the current weights back to the target weights at a consistent time interval (e.g., monthly or quarterly). The drawback with this method is that trading decisions are independent of market behavior. So rebalancing may occur even if the portfolio is nearly optimal. Tolerance band rebalancing requires managers to rebalance whenever any asset class deviates beyond some pre-determined tolerance band (e.g., ±5%). When this occurs, the manager fully rebalances to the target portfolio. While this method reacts to market movements, the threshold for rebalancing is fixed [aka: arbitrary]..."
-Massachusetts Institute of Technology

Furthermore:

Literature on [managed institutional portfolios] offers substantial evidence that institutions do not make decisions based on information or portfolio optimization. Mutual funds appear to select stocks based on familiarity (Coval and Moskowitz, 1999), sell stocks based on the disposition effect (Frazzini, 2005), engage in transactions solely for the purpose of presenting a more favorable list of stocks (“window dressing”) (Sias and Starks, 1997), and earn risk-adjusted returns lower than simple passive strategies (Gruber, 1996).
-Mendoza College of Business // University of Notre Dame

This research, along with other known techniques common to mutual fund management, should be concerning. If one were to drive their car in this same manner, only making decisions to turn or brake based on arbitrary time intervals or constraints, they'd crash! Portfolio managers need to take a more "real-time"/"event-based" approach to management; unfortunately, one would be hard-pressed to find this in most mutual funds.

The fix?

First, if you're set on investing in mutual funds, I implore you to do your research. Be aware of these concerns and address them (if necessary), even if you have an advisor.

If you're not set on investing in mutual funds and are open to other options, consider the best alternative to a mutual fund: the Exchange Traded Fund, or ETF. ETFs function very similar to mutual funds but have much fewer downsides, and many upsides; also, their fees are often considerably less.

Research shows the average expense ratio of ETFs is a mere 0.44%, much lower than the average of equity mutual funds. Additionally, in contrast to mutual funds, when you buy an ETF you own a share of it and you're in control of events that trigger tax consequences (i.e. the sale of your share). The take home message? ETFs are structured in such a manner that taxes are minimized for the holder of the ETF and the ultimate tax bill is less than what the investor would have paid with a similarly structured mutual fund.

You can do much of, if not exactly, the same things with your portfolio using ETFs instead of mutual funds. You can also consider investing in individual stocks, but this is altogether a different ball game in comparison to mutual funds and wouldn't be truly comparing apples to apples.

For more information on the benefits of ETFs and the differences between ETFs and mutual funds, visit this Forbes article: "What's The Difference? Mutual Funds And Exchange Traded Funds Explained" as well as the ETF Guide article: "ETFs vs. Mutual Funds"

Ultimately, investment cost and management transparency helps you, the client, understand how your capital is being put to work and know your actual costs for such services. Taking a lean and efficient investment approach starts with cutting out unnecessary fees and “complex” products. Now's a good time to start!

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