NEW YORK (Money magazine) -
Mutual funds are under siege, and the bad news just keeps on coming.
After three long years of rotten returns, now a rolling wave of scandal has thrown into question whether fund managers still retain enough basic integrity to deserve your trust.
Since early September, one leading financial company after another -- Alger Funds, Alliance Capital, Bank of America, Bank One, Janus, Merrill Lynch, Prudential, Strong, Wilshire Associates -- has been touched by the revelations that hedge funds and other big institutions may have churned mutual funds to the detriment of the typical investor.
The tactics that giant traders use -- late trading, market timing and trading funds in bulk -- all hurt small fund investors like us by raising costs, lowering returns and potentially even jacking up tax bills. The widening scandal suggests that all too many fund companies are willing to put their own interests ahead of ours.
But, as always happens when scandals dominate the headlines, some important truths are being overlooked. To paraphrase Winston Churchill, mutual funds might now seem like the worst form of investment -- except for the alternatives.
Do you really want to put in the time and effort to assemble and monitor your own stock portfolio? And what about the expense? Even at a discount online brokerage, commissions can easily cost you 1 percent to 2 percent a year when you buy and sell stocks yourself.
Can you -- should you -- trust a stockbroker, insurance agent or financial planner any more than you can trust a major mutual fund company?
Most fundamentally, do you -- and should you -- trust yourself? The discipline automatically imposed by most mutual funds -- instant and permanent diversification, plus the convenience of continuous investment through dollar-cost-averaging programs -- is tough to duplicate on your own.
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As the great investing thinker Benjamin Graham put it, "The average individual who opens a brokerage account with the idea of making conservative common-stock investments is likely to find himself beset by untoward influences in the direction of speculation and speculative losses; these temptations should be much less for the mutual-fund buyer." Precisely because they lack the explosive upside of individual stocks, funds help keep us from shooting ourselves in the foot.
Here's another simple and important truth: While Spitzer warns that "dozens" of fund companies may have breached their duties to investors, that's just a fraction of the roughly 650 firms that run mutual funds. The vast majority of them have not been accused of doing anything wrong.
Many fund companies care deeply about protecting your interests and conducting themselves ethically, and their actions prove it. Most important, an intelligent investor can identify these firms with a high degree of certainty.
Do you take this fund?
Would you choose a spouse or lifelong partner on the basis of a single statistic -- or would you want to know whether you share the same values and care about the same things? Would you ever pick a business partner based solely on how much money he earned -- or would you insist on knowing how trustworthy he is, how he treats his employees and customers, and whether he will always tell you the truth?
Selecting a mutual fund is no different. Why should you pick funds based on a single number -- their past performance? Mountains of statistical evidence (and nearly everyone's own experience) shows that the performance of market-beating funds is only slightly less perishable than raw fish.
It's simply impossible to pick mutual funds that will consistently outperform the market. But it's eminently feasible to pick fund managers whose business practices are beyond reproach, who treat their investors like partners and who care about more than the width of their own wallets. Because these qualities are a direct outgrowth of the character and personality of the people who run the firms, they are far more likely to endure than the ephemeral flash of hot returns.
When you buy a fund, you purchase a claim on its future performance -- a dish made of four ingredients:
-- A pinch of investment skill from the manager -- A big dollop of sheer luck -- A major chunk of the market's overall return -- A hearty helping of the way the fund manager treats clients like you
The first three ingredients are nearly impossible to measure in advance, but it's much easier to pick managers who will treat your money with great care and treat you with the respect you deserve. This story will show you how.
The 10 Commandments
Let's explore the ethical qualities you should look for and how to assess them. While many of these attributes will never appear in your newspaper's fund performance tables or on most investing websites, you can get a handle on them through a fund's financial documents and its letters to shareholders, as well as by asking the right questions when you call a fund's toll-free information service.
If the fund you're considering does not obey at least half of the rules below, then you should look elsewhere, no matter how tempting its past returns may seem. These principles are so important that I'm calling them the 10 Commandments for Fund Companies; a firm that scoffs at these ethical guidelines is probably a sinner that deserves a good smiting with a divine rod. It certainly doesn't deserve your money.
1. THOU SHALT NOT COVET. The first and most powerful test of whether the people who manage a fund are greed-heads is how much they charge to run it.
The party line in the money-management business is that to make any money a fund company needs to charge a management fee of at least 1 percent. But that's bunk. Because most fund managers can spread their own expenses across an ever-growing base of assets, the cost of running funds goes down as their size goes up.
The average profit margin of companies that manage mutual funds, according to BizStats.com, is 56.7 percent -- an astounding nine times the average profitability of American businesses. That makes running funds the most profitable major industry in the country.
Even fund companies with low fees earn high profits; most of the Janus funds charge management fees well below 1 percent, and yet Janus Capital Group (which owns the funds' management company) racked up a pretax profit margin of 27.9 percent in 2002.
John Montgomery, who runs the Bridgeway funds in Houston, says his firm will end up turning a profit on its Bridgeway Blue-Chip 35 Index Fund, even though it charges a microscopic 0.15 percent in total expenses.
There's no good reason for a fund to charge (or for you to pay) annual expenses higher than these levels: for investment-grade bonds, 0.75 percent; large and mid-size U.S. stocks, 1 percent; high-yield (junk) bonds, 1 percent; small U.S. stocks, 1.25 percent; foreign stocks, 1.5 percent. Index funds almost always charge less.
But hundreds of actively run funds -- including many from such leaders as American Century, American Funds, Fidelity, T. Rowe Price and Vanguard -- also come in under those ceilings. (Is it ever worth paying a whisker more? Only if a fund observes the rest of the 10 Commandments religiously.)
Whenever you invest with a fund company that brags about beating the market, you are gambling that the manager can keep outperforming. It's one of the fund industry's best-kept secrets that the Securities and Exchange Commission allows a manager to raise fees when a fund beats a benchmark -- but only if the manager cuts fees when it underperforms.
That leads the manager, just like you, to risk real money on whether the fund can keep beating the market. And how many fund companies are willing to take that risk? According to data from Lipper, out of 15,836 stock and bond funds with a total of $4.3 trillion in assets, only 407 funds, with $435.8 billion, carry these "performance incentive fees." The vast majority of the fund industry refuses to bet alongside its own customers.
Among the major fund companies that do charge incentive fees, and deserve a vote of confidence for it, are Fidelity, USAA and Vanguard; several smaller firms, including Bridgeway, Numeric and Turner, also use them.
2. THOU SHALT SUP AT THINE OWN TABLE. In 1998 the managers of the Kaufmann fund told MONEY that they kept virtually none of their money in their own fund, preferring municipal bonds instead. Sadly, that attitude remains all too common.
Instead of investing alongside you in the portfolios they run, many fund managers keep most of their cash elsewhere. (We can only wonder how many CEOs of rival companies might secretly be stashing their own money in Vanguard's lower-cost funds!)
Portfolio managers often invest the bulk of their net worth not in the funds themselves but in the management company that runs them. That gives them a greater stake in fattening the management fees on the funds than in maximizing the investment returns of the funds. Many firms even permit portfolio managers to trade stocks for their own accounts instead of devoting 100 percent of their attention to the funds they are supposed to be running.
But when the fund managers are themselves the biggest shareholders in their funds, they are highly likely to think like investors -- because they are.
As Robert Rodriguez of the FPA funds says, "When you own a lot of your own funds, you focus on growing your assets in a rational manner for the long term instead of getting greedy for the short term." Bridgeway, Davis, FPA, Longleaf and Tweedy Browne are among the smaller firms whose funds are owned largely by managers and directors.
Unfortunately, the SEC has not yet required fund managers to disclose the amount of their individual holdings. But the "statement of additional information," a supplement to the prospectus, must list anyone who holds at least 5 percent of a fund's shares, and may voluntarily disclose the extent of ownership by insiders.
An emphatic statement by the manager in a press interview or on the fund's website -- "I have all my money in this fund" -- is another good sign. A few companies, including Bridgeway and Longleaf, have also stated officially that they do not permit personal stock trading by portfolio managers.
3. THOU SHALT NOT BE A GLUTTON. It's like a broken record: Little fund gets hot, fund company promotes performance, fund goes cold. Small funds have the flexibility to buy a carefully selected group of small stocks, keep brokerage costs low and make sure the portfolio gets lots of attention.
But when hundreds of millions of dollars pour in too fast, the manager often has to chase bigger stocks that are no longer cheap, hiking brokerage costs and saddling him with far more stocks than he can study thoroughly. That hits performance like a bucket of ice water, prompting many of the new investors to turn around and leave.
As finance researchers Joel Dickson, John Shoven and Clemens Sialm have shown, this cycle of new money gushing into -- and out of -- a fund can trigger excess capital-gains taxes for the long-term investors.
While asset elephantiasis is bad news for outside investors, the fatter management fees on the swollen assets are great news for the manager. No wonder most fund companies can't bring themselves to close their funds to new investors before the returns for their existing investors are crippled.
If you're shopping for a fund that specializes in U.S. blue-chip stocks, asset elephantiasis is a minor concern, since size is no hindrance for such portfolios. But any fund that invests in smaller or foreign stocks can quickly get too big for your good. So it's important to buy such funds only from companies that have shown the courage to close them before it's too late.
A few small firms, like Bogle, Bridgeway, Numeric and Longleaf, have had the guts to slam their funds shut. But even such major outfits as T. Rowe Price and Vanguard have closed funds well before they got too big. The prospectus, the fund company's website or its telephone representatives should tell you about past and present closings.
4. THOU SHALT NOT BOAST. Just as Groucho Marx is said to have joked that he wouldn't want to belong to any club that would have him as a member, you should look for funds that are not desperate to have you. If the most important thing to a fund's managers is signing up new investors, that's a sign that they care more about increasing their own fee income than about improving your investment results.
Instead, you want a fund run by people who soft-pedal their past returns and keep future expectations realistic. An excellent way to see how the managers think about performance is to go back and read the fund's report from year-end 1999; it should sound notes of caution, not blasts of bravado.
Research by economists Michael Jones, Vance Lesseig and Thomas Smythe shows that funds whose advertisements promote hot returns tend to have higher risk and higher expenses, "which may produce a negative effect on future returns." (On the other hand, funds whose ads do not feature performance numbers tend to have lower risk, which should bode well for the future.)
Vanguard as a matter of policy does not use performance numbers in its ads. Torray has never run a retail advertisement since its launch in 1990, while Mairs & Power Growth didn't even have a website until 2001 and sells its shares in only 25 states. When marketing speaks in a firm but quiet voice, it's a good sign that investing is not an afterthought.
5. THOU SHALT BE PURE IN HEART. A few fund companies are so proud of what they stand for that they display their mission statements for all to see.
The first page of Longleaf's prospectus skips the usual legal mumbo jumbo and instead features the firm's "governing principles."
Why should you trust the people who run Longleaf? They actually tell you why: "We will treat your investment in Longleaf as if it were our own. We will remain significant investors with you in Longleaf. We will invest for the long term.... We will consider closing the funds to new investors if closing would benefit existing shareholders. We will discourage short-term speculators and market timers.... We will communicate with our investment partners as candidly as possible."
Bridgeway's website (www.bridgewayfund.com) features pages of detail on how the firm works to cut costs for its investors; it also runs the full text of Bridgeway's code of ethics, which prohibits employees from trading stocks for their own accounts, receiving shares in initial public offerings and accepting gifts worth more than $50. Bridgeway also donates half of its profits to charity and caps the compensation of its president, John Montgomery, at seven times the pay of its lowest-earning employee. (At last count, he earned $282,701 a year.)
This is what corporate-governance experts call transparency. When you can see right inside a firm, you can tell what it's made of. Not every company needs to be as transparent as Longleaf or Bridgeway. But if you can't figure out what a fund firm is passionate about -- if it doesn't seem to care about or stand for anything -- then shop elsewhere.
6. THOU SHALT NOT BE SHEEP. The best way to start any fund-picking decision is to remember that you can always buy an index fund instead. Unless an actively run fund offers a genuine advantage over an automated (and low-cost) index, why buy it? Unfortunately, over the past decade most fund managers have become increasingly sheeplike.
Open the portfolio of any U.S. large-company stock fund and you will find the same names with mind-numbing frequency: General Electric. Microsoft. Pfizer. Wal-Mart. Citigroup. Johnson & Johnson. Cisco. When the main difference between funds is that one has 3.07 percent of its assets in Microsoft and the other has 3.04 percent, why pretend that either manager is doing anything for his fat fees that an index fund can't do for a fraction of the price?
Afraid that they will lose business if they underperform the market by more than a hair, fund managers cluster their holdings very close to the makeup of the overall market. Yet they charge you as if they were conducting original research. They are selling tap water and pricing it like Perrier.
This "herding" keeps fund managers from producing superior returns. To see why, consider what behavioral ecologists have discovered about how birds scrounge for food. Starlings, for example, probe painstakingly for food when they are alone.
When they are part of a flock, however, they peck only where all the other starlings are foraging -- thus favoring the common "sure thing" over the rarer but possibly richer food that might lie elsewhere. Likewise, the fund manager who owns Microsoft because everyone else owns it is never going to find the next Microsoft.
So if you don't index, you should forage around for a fund that dares to be different. Look for a manager whose "R-squared," a statistical measure of how closely he tracks the market, is below 90 percent. (You can find that number under Risk Measures in the fund profiles at morningstar.com.) Among the large-company funds with low R-squareds: Clipper, Dodge & Cox Stock, Fidelity Contrafund, Oakmark, Selected American and T. Rowe Price Equity-Income.
7. THOU SHALT BE PATIENT. Odd, isn't it, that most fund managers always seem to own the same stocks -- and yet they constantly trade them? According to Morningstar, the average large-growth fund has a 184 percent turnover rate, meaning that it holds its typical stock for only 6ª months. And yet the annual expenses on such funds average 1.54 percent -- most of which supposedly goes to "research" those stocks.
No one has ever diagnosed this schizophrenia better than Robert Torray of the Torray Fund. "The fund industry spends zillions of dollars on research, and then you get turnover in popular funds of 100 percent a year," he once said. "What's the difference how much you know about a business if you don't keep it for a year?"
Finance professors Josef Lakonishok, Andrei Shleifer and Robert Vishny looked at the returns of 769 pension funds over a multiyear period. They asked how the funds would have performed if they had "frozen" their portfolios by doing no trading at all. On average, the funds would have increased their returns by three-quarters of a percentage point a year!
You're paying good money for the fund manager to research stocks. In turn, he darn well better learn enough about them to hold them for more than a measly 195 days. Most of the American Funds hang on to their typical stocks for more than three years; Torray holds on for over four years on average; Dodge & Cox Stock sits tight for more than seven years; and Mairs & Power Growth, the Rip van Winkle of mutual funds, sticks to its picks for more than 20 years at a time. Patience pays: All these funds have superb returns.
8. THOU SHALT NOT TAX. Is a fund going to work for you or for the IRS?
A recent study by Lipper found that after all sales charges and expenses, equity funds earned an annual average of 6.79 percent over the 10 years ending in 2002. But taxes ate up two percentage points of performance, leaving the typical investor with just a 4.8 percent yearly return. (Of course, that applies only to nonretirement accounts. It assumes you paid tax at a 28 percent rate and never sold.) In short, careless or indifferent management by fund companies has cost taxable investors nearly one-third of their total return over the past decade.
If the fund managers are themselves the biggest shareholders, it's a safe bet that they will keep the tax bill down. Low portfolio turnover can be another indicator of a tax-wise approach. The SEC recently mandated disclosure of pretax and after-tax returns, so you soon will be able to find in the prospectus an estimate of how much of a fund's performance is eaten away by taxes. (If taxes have devoured much more than 10 percent of returns, go elsewhere.)
Index funds are almost always highly tax-efficient, but actively run funds can score well too, when the managers care: Among tax-friendly funds are Fidelity Dividend Growth, Jensen, Meridian Growth, T. Rowe Price Blue Chip Growth, Third Avenue Value and Vanguard Primecap.
9. THOU SHALT SCOURGE THE GREEDY. Has a fund company put out the welcome mat for market timers and other fast traders? Turn to the back of the prospectus, where the fund must disclose its policies and procedures on sales and redemptions.
Normally you want to avoid a fund with extra fees, but a "short-term redemption fee" is one charge you should cheer. Anyone who can't hold on to a fund for at least 90 days at a time is not an investor; he's a speculator, and he deserves to be punished for raising your costs and lowering your returns. That's why good funds charge up to 2 percent in short-term redemption fees -- and why the SEC should drop its silly objection to even higher penalties.
These fees go back into the fund, not into the manager's pocket, so they benefit the loyal long-term investors. Bridgeway even imposes a special 2 percent redemption fee if the stock market has dropped at least 5 percent in the previous week, discouraging shareholders from selling in a panic.
You should also look for funds that use fair-value pricing to adjust their net asset value for late-breaking news, thus discouraging market timers. Watch too for "confirmed" or "delayed" redemptions, which a fund can use to compel a speculator to wait several days to get his money back.
Many funds also threaten to redeem the shares of short-term traders not with cash but with a proportionate share of the stocks in the fund -- a nasty prospect that may deter market timers. (Although the Spitzer investigation alleges that many fund companies did not abide by these provisions, they're probably too scared not to adhere strictly to the rules from now on.) If a fund's prospectus says nothing about how it combats speculators and encourages long-term investors, skip it.
10. THOU SHALT LOVE THY NEIGHBOR AS THYSELF. While most fund companies like to call themselves families, it's fair to ask what sort of family would treat its own members like complete strangers.
Most fund managers insist on having a profoundly remote relationship with us: When we buy a fund we write a check, send it off to a P.O. box in some far-off city and cross our fingers that our hard-earned money will be well taken care of by somebody we will never meet or get to look in the eye, whose hand we will never get to shake. How can we be sure this person deserves our trust?
We can only guess and hope for the best. It's no wonder that the latest scandal has shaken the public's faith: Other than bragging about performance, what has the fund industry done to build an emotional bond with its investors? When hot returns go cold, what else about a fund can investors cling to?
Sociologists and other researchers have shown that it is easier for people to sustain their belief in a religious or political movement if the organization features charismatic founders or dynamic followers as its public face, showcases a broad set of beliefs, has loyal and vocal members, and works hard at fostering a cohesive community with shared values and a strong sense of belonging.
By those standards, most fund companies fall far short. And that's a shame -- not just for them but for all of us. If the only cause for loyalty a fund has ever given you is its hot returns, then your faith in the fund will always be as perishable as its performance. If, however, the fund company reaches out and makes you feel like part of a community, you are more likely to ride out any performance bumps.
At the FAM funds, employees personally call each new investor "to say 'welcome' and let them know there's always a live person for them to talk to at FAM," says spokeswoman Susan Lhota. FAM also holds an annual meeting at which its investors share doughnuts and apple cider with the fund managers and directors.
A handful of other outfits, including Aquila, Ariel and Longleaf, hold similar conclaves where investors can shake the fund manager's hand and look him square in the eye. Investors travel hundreds of miles to these meetings to get a sense of whether their money remains in good hands.
That's not the only way funds can foster a sense of community. They can write shareholder letters worth reading, as Clipper, Oakmark, Third Avenue and Tweedy Browne do. They can treat you like an adult and speak the unvarnished truth, as the Royce funds do in reports that highlight their losing stocks as well as their winners -- or as IPS Millennium does when it warns that "sometimes we get killed anyway when high-tech and other growth stocks take a particularly big hit. The 'we' is actually a euphemism for you, got it?"
Being "candid in our reporting to you" is one of Warren Buffett's core principles. Thousands of Berkshire Hathaway investors flock to Omaha each May not just because they are grateful that Buffett has made them rich, but because he makes them feel that they belong.
The precious few mutual funds that make investors feel like family deserve your loyalty and your trust. Let's hope the latest round of scandals finally prompts more fund companies to build a bond with their investors based on factors far more durable than the elusive promise of beating the market.