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June 11, 2008

Mutual Funds Don't Keep You Diversified

I'm traveling with a group of wonderful Snider Method alumni in Alaska this week, but I wanted to break for a moment to discuss one of my favorite topics: Mutual Funds.

I've written a lot about Mutual Funds on my blog, but I haven't addressed one of the biggest misconceptions about them for a while. Many investors get sucked into mutual funds, thinking that they provide instant diversification. This may have been true in the past, but for the most part, it isn't true anymore.

Actively-managed mutual funds have largely outlived their original purpose. The reason they came into existence was to allow investors to pool their assets and get diversification with a fairly small amount of money.

Everyone still believes that by buying mutual funds, they are diversified. Most actively managed funds really aren't diversified, though, for two reasons.

The first reason is known as "style slip," and here's how it works. Let's say you buy into Kim's Small-Cap Value Fund. The prospectus tells you that the fund will invest in small-cap stocks that the manager (in this case, me) believes are undervalued. So you assume that you'll be investing in just that -- undervalued small-cap stocks.

As we know, the market doesn't all go up and down at the same time. Certain sectors will outperform or underperform others. For example, in 1997 small-cap value didn't do so well while large-cap growth stocks were going up like gangbusters. So let's say Kim's Small-Cap Value Fund was only returning 6 or 7 percent around that time while the market as a whole, driven by large-cap stocks, was up 23 or 24 percent.

If you were an investor in my fund, what would you do? You'd most likely sell, wouldn't you? Even though my objective as a fund manager was to buy small-cap value, I know that if I don't perform close to the market in general, I'm likely to lose customers. So that makes me a closet indexer. I aim to get close to the indexes, regardless of my stated objective, because badly underperforming the benchmark index is death to a fund manager.

So even though I say my objective is small-cap value, I'm only going to invest that way when that sector is doing well. The rest of the time, I'm going to invest in whatever else is doing well. Because all the other fund managers are doing the same thing I am, we all wind up buying the same stuff.

What this means to you, the investor is this: You own several different funds, but they all own the same stocks! You may have a percentage in a small-cap value fund, some in a large-cap growth fund, some in mid-cap, some in international, etc., but it doesn't really matter. All the managers put you in the same things. You really aren't diversified.

The second reason mutual funds don't offer the diversification you expect is more systemic. Globalization has changed the way we should diversify to create uncorrelated asset classes. For example, we used to think that stocks and bonds always moved in opposite directions -- as stocks go down, bonds go up -- but that doesn't hold true anymore. We used to buy international stocks because they tended to move in opposite directions of U.S. stocks. Now they're a lot more intertwined.  So although an investor may go out and buy different funds in the hopes of getting several uncorrelated asset classes, they wind up all moving in much the same direction at the same time.

So if one of the main jobs of actively managed mutual funds was to provide diversification, and they can't do that job anymore, why are we still investing in them? Combine the lack of diversification with the track record of lousy performance compared to the indexes, and you should realize that you can do a lot better.

SOURCE
1. Jackson, David. "ETF Investing Guide: So You Thought Mutual Funds Help You Diversify?" Seeking Alpha, 1 July 2006. http://seekingalpha.com/article/15159-etf-investing-guide-so-you-thought-mutual-funds-help-you-diversify (accessed 4 June 2008)

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Kim Snider is the President and Founder of Snider Advisors, an SEC Registered Investment Advisor, focused on teaching individual investors a sensible, long-term investment approach focused on maximizing cash flow. For more information on Snider Advisors or the Snider Investment Method and how to stop enriching your investment advisors at your expense, please visit snideradvisors.com. Her book, How to Be the Family CFO: Four Simple Steps To Put Your Financial House in Order, will be in bookstores October 1, 2008.

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.

Posted by Kim Snider on June 11, 2008 | Permalink