I spent several days this week in New York and Chicago meeting with reporters from the Wall Street Journal, Dow Jones News Wire, Smart Money, The Street.com and others. (This is a picture I took, with my cell phone camera, of the New York Stock Exchange. Look to the right at the guy with the helmet, flak jacket and rifle. The military-like security was kind of unsettling.) Anyway, as I made the rounds, talking with reporters about Snider Advisors and the Snider Investment Method, I had the opportunity to give them my take on the problems with traditional investments.
We talked about traditional cash flow investments like bonds, preferreds and dividend paying stocks - none of which pay enough. We talked about the reverse compounding problem with a capital appreciation portfolio. I gave Janet Paskin, from SmartMoney, an unscheduled earful on variable annuities.
But looking back, it occurs to me, I never even talked about one of my favorite whipping posts - actively managed mutual funds. In fact, I can't think of the last time I wrote about the systematic fleecing of unsuspecting mutual fund owners.
What has gotten in to me? I must be getting soft! You know what? I have two hours to kill on this flight. How about we haul them out - just for old times sake?
First of all, mutual funds cover a pretty broad spectrum. There are funds that invest in stocks, bonds, money market funds, REIT's - all kinds of stuff. For now, let's limit the discussion to funds that invest in stocks.
There are closed end funds which trade on the exchanges, similar to a stock, and then there is what we think of as the more traditional fund, where you purchase your shares from the mutual fund company, either directly, or through a broker. Within that category, there are actively managed funds and passive funds or index funds.
An actively managed fund is one where the fund manager is picking stocks, based on whatever criteria he or she uses, in an attempt to outperform the market. An index fund just holds the stocks in the index it is trying to mimic and only changes those stocks when the stocks in the index are changed. Other than that, they rebalance on a constant basis to make sure the fund reflects the weightings of each stock in the index, and that is all that is done.
My beef is with actively managed, equity mutual funds. I will tell you right off the bat that I am not a fan of actively managed mutual funds. In fact, people kid me. You know how companies have tag lines that go with their company name, like “Built Ford Tough” or “Like A Rock”? People tease that my company tag line should be “We'd Rather Stick Pins in Our Eyes than Put Money in a Mutual Fund!”
The problems with actively managed funds fall into three broad categories: 1) Lack of control; 2) Lack of transparency; and 3) Lousy performance. I will outline each of these three areas briefly and then expand on each over the next few weeks.
Too often I see people who are like leaves - just floating along in the current. Wherever it takes them is where they will end up. This is no way to manage your investments. If you care about reaching your financial destination, I believe you have to grab hold of the rudder and steer. With mutual funds, you completely give over control to someone else.
You do not control what stocks the fund invests in or whether the fund even sticks to its stated investment objective. This is known as style slip. You don't control who is managing your money or what they are investing it in.
You also don't control when the fund makes taxable distributions. This makes planning difficult and in certain situations, this can cause you to pay unnecessary taxes or penalties.
Transparency is the second problem. In fact, it is Wall Street's biggest problem. But I won't go down that rabbit hole for now.
You don't really know what your mutual fund owns. It generally only reports the top holdings and often well after the fact. Many mutual funds actually invest in exchange traded funds but few include that information when they report their holdings.
The combination of style slip, also known as closet indexing, globalization, and lack of transparency in fund holdings, makes it difficult - if not impossible - to create a truly diversified portfolio. You would be amazed at how correlated, if not actually duplicative, the holdings of your various funds really are.
And speaking of those exchange traded funds inside a mutual fund - why don't we hear more about that? The fund buys an exchange traded fund that mimics the index. That does two things. It adds an undisclosed layer of costs - the management fee of the ETF. But what should really burn investors is the fund manager continues to charge you active management fees. The fund is basically charging you for work it did not do! What the heck is that about?
Also, did you know that the way mutual funds are required to report their returns, doesn't tell you how much an investor in that fund would have made or lost? Their return numbers tell you how much the stocks in a funds portfolio went up or down - but they don't tell you how the fund's investor's fared. Often, that is a very different story depending on the timing of the investment.
More disconcerting, you don't really know what you are paying for management. There is no line item showing the debit for fees. They are hidden. And don't count on the prospectus to clue you in.
There are three layers of costs that do not have to be disclosed in the prospectus: transaction, market impact and spread costs. Academic studies indicate these costs can add an additional 2% to the stated management fee.
I probably wouldn't get my hackles up over these fees if the performance of these portfolio managers offset the costs, but they don't. According to Morningstar, the average domestic equity fund with a track record of at least 15 years, trails the S&P 500 by 2%. So what are we paying them for?
Does 2% matter? Oh my gosh does it matter! Do the math.
Let's take an average actively managed mutual fund with an expense ratio of one and a half percent, which is cheap compared to many mutual funds. Let's compare that with a low expense strategy that has a hypothetical expense ratio of .2 percent. If we apply that to a $250,000 investment and assume that both can earn 10% compounded over the next 20 years, the difference is almost $378,000.
Now consider your required rate of return. To pay yourself 4% of your portfolio each year in retirement, keep up with the historical rate of inflation and pay Uncle Sam at a marginal tax rate of 25%, you have to earn a 10% return. The formula is the withdrawal rate plus the rate of inflation divided by one minus your marginal tax rate, or (.04 + .035) / (1 - .25) = 10%.
If your required rate of return is 10% and your mutual funds return 2% less than their benchmark indexes because of the drag from fees, can you afford to invest in mutual funds?
Bottom line - you can do better.
Kim Snider is the President and Founder of Snider Advisors, a SEC Registered Investment Advisor, focused on solving the problem of retirement income for long-time planners, savers and investors who still find themselves wondering if they will have enough. For more information on Snider Advisors or the Snider Investment Method and how we may be able to help you make your retirement savings go farther than you thought, please visit snideradvisors.com.
Snider Advisors makes no representation that the information and opinions expressed are accurate, complete or current. The opinions expressed should not be construed as financial, legal, tax, or other advice and are provided for informational purposes only. Call 866-952-0100 to request the Snider Investment Method™ Owner's Manual, which includes a description of the Snider Investment Method, investment objectives, risks, suitability and other information. Please read and consider carefully before investing. All investments, including the Snider Investment Method™ are subject to risk, including possible loss of principal.
