Any mental-health professional worth his salt will tell you that striving for excellence is a really lousy idea. It’s about the worst possible thing for your peace of mind. That theme has been hammered at time and again by psychotherapists in numerous studies, as researchers advance the fight against mood disorders. In his seminal work, Feeling Good: The New Mood Therapy, the noted psychiatrist Dr. David D. Burns observed that “the harder you strive for perfection, the worse your disappointment will become because it’s only an abstraction, a concept that doesn’t fit reality.” His advice: “Dare to be average!” This sensible repudiation of perfectionism and mediocrity-phobia has been a path to contentment for thousands of people—including untold numbers of happy, well-adjusted mutual fund portfolio managers.
Mutual funds dare to be average. In fact, they dare to be lousy. They have long since ceased striving for anything resembling perfection when it comes to managing your money. They must be happy about it, because they have been bastions of mediocrity since the backward-pricing, embezzlement, and customer-screwing days of the Roaring Twenties.
You’ve probably heard that funds are a terrific place to keep your money over the long term. Bull market and bear, the long-term investor is the tortoise that beats the hare. It’s appealing. It even rhymes. It makes a lot of sense until you realize how mediocre fund managers truly are. If you had shares in an equity mutual fund on January 1, 1984, just as the bull market was taking off, and held on to it until December 31, 2003, the chances are better than 90 percent that your fund failed even to match the performance of the Standard & Poor’s 500 stock index. Now, if that’s not a repudiation of perfectionism and all the agita that comes with it, I don’t know what is.
I say “better than 90 percent” because that number includes only the funds that survived for the entire twenty years. The real doggies, the ones that choked on their own saliva, are excluded. And that could be a lot of funds, particularly when you’re talking long-term. One study found that of 361 funds that were alive and well and taking your money in 1976, seventeen years later 72 had been merged out of existence, usually because of crummy performance, and 37 were lured into station wagons by men in raincoats and wound up on milk cartons. They just vanished—with “no indication of what happened to them.” So 90 percent is an underestimate of the chances that your mutual fund sucked wind.
Contrary to the prevailing wisdom of personal-finance journalism, buying into an actively managed mutual fund is not a “prudent” and “sound” exercise in “portfolio diversification.” It is actually a “dumb” and “asinine” exercise in “paying people to do a lousy job of managing your money.” You pay them handsomely to be mediocre, and you even pay for the ads in which they proclaim, and you pay for the flacks and data vendors who sucker the media to co-proclaim, that they do not stink but actually do an outstanding job in managing $8 trillion and counting of your money.
The real Mutual Fund Scandal is not trading, late or otherwise, but happiness. Fund managers are happy people with high self-esteem who draw fat salaries and bonuses for jobs that could literally be performed by nobody—an unmanaged index fund that mechanically invests in the S&P 500 or some other index. Fund companies cheerfully overcharge you for inflated fees and expenses, trade too much, pay through the nose in commissions, and overpay their pals in the brokerage industry in return for office space, research, and other perks, with you footing the bill. They are not neurotic or hesitant as they overcharge you. They do not cut back on their fees out of a self-destructive sense of shame or for a dysfunctional reason such as “doing a crummy job.” Fund managers are blessed with healthy psyches. They confidently charge you fees that they don’t deserve whether they are making or losing money, and they have job security that would make a postman envious.
If you do a sloppy job painting someone’s house or designing a company’s Web site, you’ll be tossed out on your ass. But if you are hired by a fund-management company to manage money—in the dipsy-doodle language of Wall Street they call this an “advisory” contract even though they’re not “advising” but running things—you are as snug as a nephew on the CEO’s payroll. Above all, you are happy because mediocrity is embedded in the DNA of the fund business. People expect it. It is not a shameful thing. It is treated not as an infirmity but rather as a trait, like being left-handed.
I’d like to put a price tag on what I’ve just described, but I hesitate to do so, not because such figures are hard to come by but because you won’t believe me. What you have to keep in mind is that the amount of bucks involved is a special species of humongous. Even after you comb out the $1.9 trillion in money market funds and the $600 billion in index funds, that still leaves $5.6 trillion of your money they’re playing with. That counts bond funds, which also have been found to underperform their indexes. We’re talking fifty-six hundred billion dollars.
Imagine a city the size of Kalamazoo where everyone has Dick Grasso’s bank account—that’s the kind of bucks we’re talking about here. So when you read that, for example, $10 billion of your money is siphoned off each year to lure in other suckers—a U.S. government-certified scam called 12b-1—you have to remember that this is just a fly speck on the rhinoceros rump of the fund industry.
This is all easily quantifiable. These aren’t rough estimates that some economist or “expert” has dreamed up. In the official Mutual Fund Scandals, with the golden-oldie scam of late trading at center stage, it’s hard to figure out how much investors were hurt. Fund assets were hurt, but indirectly. Thus the amount late traders supposedly glommed off the Putnam fund group was calculated at $10 million in mid-2004. Then a consultant recalculated the figure in early 2005, and it was suddenly $100 million.
The real Mutual Fund Scandals are straightforward. No complicated formulas or consultants are required to determine how much people have been skinned. Nor is there any esoteric trading scheme that requires paragraph upon paragraph of explanation. The real scandals involve Sunday School morality and simple concepts, such as “taking.” The money is there, so they take. You would too, if you had a few trillion bucks in your hands. You might even take more than they do, though you wouldn’t have to.
Another trait of the real Mutual Fund Scandals is that they are not the kind of things that can be cured by regulation—and most definitely not by the anemic, almost goofy regulations that Bill Donaldson made such a show of proposing at the SEC, and which got the U.S. Chamber of Commerce so upset. This is one of those situations in which doing things that get people angry in Corporate America doesn’t necessarily mean that you are being the slightest bit pro-investor or pro-consumer. As we’ll be exploring in the next chapter, the SEC’s approach to mutual fund regulation, in the post–Spitzer-rammed-it-down-their-throats era, has been downright silly. But even if the ideas were sensible, they wouldn’t do very much good anyway.
They can cut down entire forests to print volumes of the Federal Register with regulations that get the U.S. Chamber of Commerce mad enough to sue, and that would still not get at the heart of the problem—which is that people let themselves be skinned by mutual funds. You’re the cow they are milking, and nobody is forcing you to let them yank your teats. The answer isn’t a new law or regulation, and it isn’t Eliot Spitzer or Eliot Ness or even Robert Stack in the role of Eliot Ness. The answer is the one I mentioned at the beginning of the book: you. You need to know how the fund industry works, and what it does with your money, and then you have to decide what to do about it.
The real Mutual Fund Scandal, as opposed to the one that has laid siege to the headlines, involves the fundamental issue of fund performance—the real numbers versus the touted numbers and the ratings that you see everywhere. That is the elephant in the room, and involves uncomfortable facts that the fund industry and media don’t want you to know. In this chapter I’ll take that elephant by the tusks and parade it in front of you, and in the next chapter I’ll describe the rest of the real Mutual Fund Scandal—assuming you’re not so disgusted by then that you want to just skip it. Maybe you’ll want to cash out entirely, or maybe you’ll want to keep investing in actively managed funds even though the odds are stacked against you. Hey, it’s your money. There are a lot worse things you can do with your bucks than giving them to even a mediocre mutual fund—such as, for example, giving them to a mediocre hedge fund. If supporting the lifestyle of a mediocre fund manager is your favorite charity, who am I to stop you? If not, read on.
As you may have noticed if you subscribe to the financial press, mutual fund reviews and scorecards appear every three months in the media. The ones that appear in January, describing the previous year, are always big sellers, and are usually packed fat with advertising from the fund industry. That’s understandable, since just about everyone owns a mutual fund, either individually or through IRAs or 401(k) plans. The purpose of these regular doses of mutual fund propaganda is to pump you up and get you into a buying mood. You have plenty of choices. There were 4,551 equity funds, 2,040 bond funds, and 510 hybrid funds, investing in both stocks and bonds, as of year-end 2004.
In early 2005, the annual fund reports were upbeat. The market had just risen 11 percent during the previous year, as measured by the S&P 500, but 2004 had been uneven. The conventional wisdom is that such years are stock picker’s markets, in which “savvy stock selection” carries the day. The January 2005 reports showed that mutual funds had indeed done a pretty good job of picking stocks. The Wall Street Journal, Barron’s, the New York Times, and personal finance writers throughout the country all ran stories driving home that point, as did widely followed fund-watching outfits such as Lipper and Morningstar, saying that the average fund had beaten the S&P.
“An indulgent dessert can sometimes brighten the memory of an otherwise mediocre meal. So it was last year in the markets, when a sweet fourth-quarter rally gave owners of stock mutual funds plenty to rave about.” That was how Barron’s began the lead story of its Mutual Funds Quarterly on January 10,2005. The title was “Sunny Returns.”
According to the Barron’s assessment of the previous year’s tidings, the sunshine was particularly intense among small-stock funds. That made sense. This was a stock picker’s year, and small-cap stocks are an area in which intensive research is said to pay off. “Right in the sweet spot of the market trend were small-cap value funds, which benefited from favoring cheaper and smaller shares over blue chips,” said the weekly. That category of funds, the article continued, “was up 20.9% last year, and its five-year annualized return sits at a gleaming 16.2%, versus small losses over that period for the broader market.” A couple of pages later, a chart showed that “small-cap growth” funds were up 10.7 percent during the year, and that “small-cap core” funds were up a much nicer 18.4 percent. So it was generally a terrific year for small-cap fund investors, when compared to the S&P 500 index, which Barron’s used as a benchmark, or point of reference.
You might think, after reading the Barron’s piece and similar annual fund-review stories, that the 90 percent number quoted earlier was from some crackpot with an ax to grind. After all, Barron’s is the most sophisticated investment publication in general circulation, and its various statistical sections and articles have a wide following among investment professionals as well as serious amateurs. Any fool could see that funds beat the indexes hands down in 2004. It was a “stock picker’s market” and the returns were “sunny.” So said Barron’s and so said the rest of the media.
Actually, fund returns seemed sunny only if you hadn’t been outside very much. Another set of statistics came out a week or so later from the number crunchers at Standard & Poor’s, and these told a different story. You might have surmised from the media coverage that fund managers were a neurotic bunch of perfectionists, striving for excellence and succeeding. The S&P study, however, indicated that fund managers were hewing closely to the principles of good mental health by striving to be average.
S&P found that most actively managed mutual funds—excluding funds that just mechanically replicate stock indexes—actually had done a mediocre job in 2004. The S&P Composite 1500, a broad market index, outperformed 51.4 percent of actively managed domestic general-equity funds. The S&P 500, which is the most widely followed large-cap index, outperformed 61.6 percent of actively managed large-cap funds in 2004, while the S&P MidCap 400 outperformed 61.8 percent of actively managed mid-cap funds. Here was the real kick in the rump—those performance numbers that you read in the business press were skewed in favor of the fund industry. It seems that large-cap growth funds were the only diversified equity funds to beat the market in 2004, and eight of the nine fund investment styles tracked by S&P actually had average 2004 returns that underperformed the market.
As for those small-cap funds that supposedly performed so sun-shinily throughout 2004—well, there were a couple of things that Barron’s, along with the media in general, forgot to tell you in their quarterly mutual fund lovefest. They said that small-cap funds did a wonderful job, but that assessment was just a bit off base. They actually did a horrible job—I mean fall-on-your face, kick-in-the-ass, humiliatingly lousy.
Sure, the small-cap funds beat the market—if by “market” you mean the S&P, which didn’t do as well as small-cap stocks generally. If you compare apples to apples—small-cap funds to small-cap indexes—what you find is that actively managed small-cap funds actually underperformed the market averages for that category of stocks.
In an absolute sense, as opposed to the “comparison to whichever benchmarks we choose” sense preferred by money managers, small-cap value funds did very nicely in 2004. It was certainly a better idea (assuming you were a comic-book superhero who could foresee the future) to put your money in a small-cap fund at the start of the year. But that’s because small-cap funds were carried along like kayaks in white water, not because their managers were good oarsmen.
During 2004, the S&P/Barra 600 Small Cap Value Index was up 23.3 percent. The average comparable fund underperformed the index—by four percentage points, according to S&P, or two points according to the Barron’s data source. As a matter of fact, these figures don’t show the full breadth and scope of the crumminess of small-cap fund managers in 2004. During that year, 85 percent of actively managed small-cap funds were beaten by the S&P/Barra index. The figure for small-cap value funds was almost as bad, 77 percent, and for small-cap growth funds it was a tongue-swallowing 94 percent. S&P also found that most funds were also beaten by the indexes over three and five years as well.
Now, I don’t mean to beat up on Barron’s, actually one of the better financial-news outlets. Its coverage was fairly typical of the fund stories that you find throughout the media. To be fair, I also have to point out that S&P is not an entirely disinterested party. It makes big bucks off its indexes, charging fees when they are used for index funds, futures contracts, options, and exchange-traded funds (ETFs) that are based on the S&P 500 and other S&P indexes. To balance that out a bit, it also makes money from the mutual fund craze by operating a fund-rating business. Its corporate compadre Business Week, also owned by McGraw-Hill, takes in serious bucks in mutual fund advertising, and also, like most of the press, ignored the S&P findings. But let’s disregard all that for a second. Let’s assume these S&P numbers are bogus and throw them in the garbage. Let’s see what other researchers have to say.
Academic researchers have been studying mutual fund performance for a long time and they have plenty to say—most of it none-too-flattering. Studies have proven consistently since the 1970s that mutual funds do not beat the market. Those studies were of only academic interest in the days when there were limited index fund alternatives for investors. But today they are required reading for every investor, now that anybody can buy into one of the dozens of index funds or exchange-traded funds—stocks that track the indexes, such as the “Spiders” and “Diamonds,” modeled on the S&P 500 and Dow Jones industrial average, respectively.
Today those indexers are widely available, yet the academic and scholarly studies that prove the consistent superiority of index funds get only grudging attention from the media. One came out in the same month in which the media was engaged in its quarterly mutual fund kissing competition. A scholarly publication called The Financial Review published a paper by a professor of finance at Princeton University named Burton G. Malkiel, describing in meticulous detail how poorly mutual funds have stacked up against the indexes over the years.
Malkiel’s figures made the S&P numbers seem understated by comparison. He found that in 2003, 73 percent of actively managed funds failed to beat the S&P 500. The failure rate was just as bad over the long term—72 percent over three years, 63 percent over five years, 86 percent over ten years, and (this is the source of that number cited earlier) 90 percent over twenty years. The very oldest and most long-lasting funds were generally losers.
These numbers seem all the more distressing when you realize that Malkiel is not some crank, but is one of the most esteemed financial authorities alive. His book A Random Walk Down Wall Street is the bible of a financial school of thought called the Efficient Market Hypothesis. The EMH is one of the most widely respected theories of modern finance. Now that the growth of index funds and ETFs makes it easy for every investor to put its principles to work, the EMH is something that everybody needs to know. Apply its principles and you can never be ripped off in the stock market again. That’s because you will never buy an individual stock again.
With Random Walk as its Big Book, the EMH functions as a kind of 12-step program for stock addicts. Malkiel doesn’t quite phrase it this way, but his book and its underlying theory very much address the American public’s addiction to the purchase of individual stocks. Step one is familiar to every alcoholic and overeater and smoker and procrastinator: We admitted that we were powerless over stocks, and our lives have become unmanageable.*
The EMH teaches that you can’t beat the market. You are powerless to predict stock prices. Don’t “pick up” (buy stocks)! Stay out of taverns (brokerage offices)! Your Higher Power is the market. The market will go up, and it will go down. When it does well, and it will over time, you will too. You can do no better. Be happy with that. Don’t be greedy.
The EMH originated back in the mid-sixties. Eugene Fama, Malkiel, and other early proponents of the theory are real investor heroes. That’s not only because application of the EMH saves investors from subpar returns and investment ripoffs, but because it has spurred research that has produced a good deal of very valuable data. The EMH says, in essence, that no matter how much you might knock Wall Street, the stock markets themselves are blessed with a certain purity. Stock prices reflect all publicly available information.
There are, of course, plenty of inflated share prices and frauds out there, and scores of stock promoters, newsletter writers, and so on who spout all kinds of drivel about stocks. That doesn’t mean the EMH is wrong. The EMH teaches that shares reflect all available information—not that the available information is true. But try to exploit those market inefficiencies and the odds are stacked against you.
The EMH is, as its name indicates, a hypothesis—a theory. You can choose to believe it or not, as you wish. Wall Street (which in this context includes the entire money-management industry) is firmly in the not-believing camp. That’s because the more investors adhere to the EMH, the fewer profits the Street gets at your expense. The Street views the EMH and its proponents the way you might feel about a war-veteran uncle who nods off after telling an after-dinner story about Nam. You can’t really contradict him, as it wouldn’t be very polite, so you just ignore him. No reason to get hepped up about the EMH. It isn’t widely known among the people who count—the millions upon millions of people who buy individual stocks and actively managed funds.
What makes the EMH heresy for Wall Street is that Malkiel and other advocates of efficient markets have found, and demonstrated quite often, that entire segments of Wall Street have no basis for existing. “Savvy” stock pickers, the EMH people say, are just lucky. Smart analysts are lucky. Smart fund managers are lucky. Trading is a waste of money. These are not wacko theories. There is data in support of them—lots and lots and lots of data. If people acted on all that data, it would mean that all the “ace money managers” who you read about in the papers, the ones with the “terrific track records,” all the Institutional Investor–certified analysts and hedge fund gurus and guys riding around on motorcycles looking for investment ideas—the whole bunch of them would be replaced by computer chips at index funds. Stock market newsletters would go out of business or be reduced to ranking the various varieties of index funds, and dozens of stock-pushing Web sites would vanish overnight. Entire industries would shut down, and one of them would be the mutual fund industry.
All this explains why your broker would rather his clients be Marxists who like to gamble than free-market capitalists who embrace the Efficient Market Hypothesis. That goes double for the mutual fund industry.
The numbers are pretty dramatic, when you consider how much money is poured down the drain in fees paid to people to actively manage your money. Let’s go back to that $5.6 trillion figure I mentioned earlier. Multiply that figure by 1 percent. That is the amount of money that the mutual fund industry takes out of that figure in expenses. It’s a little less for bond funds and a bit more for stock funds, but it averages out to about that number. That figure is an underestimate because it doesn’t take into account commissions and “advisory” fees, as we will be seeing in the next chapter. But let’s use that number as a conservative estimate.
One percent of $5.6 trillion is $56 billion. That is what you pay fund managers to pick stocks and bonds and manage all those mutual funds. If all that money were to be invested in index funds instead, that 1 percent number would shrink way, way down to 0.2 percent. Multiply 0.8 percent times $56 billion and you come up with $44.8 billion. That’s how much you’re paying the fund industry every year to do a lousy job.
Not all that money goes directly into the septic tank, of course. A lot of it goes tearing back through the economy, just as a good deal of the money used to purchase methamphetamine in Camden, New Jersey, is used to buy beer, video games, and other mainstays of the local Camden, New Jersey, economy. So I’m not going to say it is all a waste. That is for you to decide. The only question that you need to ask yourself, the next time you get a bonus or some other sudden money, is whether you want to roll the dice on the next hot fund manager, or surrender to the Higher Power of the stock market and put your bucks into an index fund or ETF.
Fortunately for the Street, the EMH hasn’t proven to be much of an albatross because there are always plenty of “hot fund managers” and “investment gurus” able to prove—until they stumble—that they have beaten that EMH thing into the ground. And when the laws of probability catch up with them and they do stumble—well, memories are short. The three hedge fund superstars of the 1990s—George Soros, Julian Robertson, and Michael Steinhardt—were forced to shut down (or, in the case of Soros, reorganize) after making serious investment and trading blunders. All provided subpar returns for any investors who were able to buy into their funds when they were being hyped the most. At the time of his funds’ descent into the Valley of Fatigue in early 2000, Robertson was blaming an “irrational” market for his failure. That was true. Markets are random, irrational, and inexplicable—that is what the EMH is all about. * Yet well into the new millennium, these living proofs of the EMH were still being touted as market seers by the financial press. In December 2002, Robertson predicted that “in the next year or two, we’re coming into a very long-term problem”—and the market promptly rebounded, gaining 29 percent in 2003 and 11 percent in 2004. Irrational!
Mutual funds don’t spawn overhyped “legends” as much as the hedge fund industry does. Instead they have a caste system of the kind that was outlawed in India when it broke away from England in 1947, but which still exists in accordance with religious principles considered no less holy than the ones used to rate mutual funds. The Brahmans of the mutual fund subcontinent are the five-star funds, while the Scheduled Castes, the untouchables who are shunned and prohibited from using the same wells and public bathing facilities as the higher-caste funds, are one-stars. They live in a shantytown at the outskirts of the village. Even writing about them makes my fingers dirty, so I will have to perform an ablution after I finish this paragraph.
A number of very reputable and highly prestigious organizations provide fund caste ratings. Business Week has participated in the fund industry caste system for many years, using data supplied by Morningstar, Inc. So has Barron’s, whose data are supplied by Lipper. These are both reputable firms that make good-faith attempts to determine whether a fund will do well. They do so by examining the funds’ past performance.
The only problem in examining past performance is that, as the funds themselves are legally obliged to tell you, “past performance is no guarantee of future results.” That exact language can be found strewn around all the fund advertising and fund Web sites, and is used so often that people tend to ignore it, the way they ignore warning labels on cigarette packs. Both warning labels are required by law because they’re true. Cigarettes cause cancer, and buying a fund because it performed well last year is stupid. Today’s low-caste fund, even one of the untouchables, might well rise out of the misery of its existence and ascend to a higher caste tomorrow. This is democratic, I suppose, but it also makes the whole fund caste system kind of silly.
The good professor Malkiel concluded in his recent study that “while highly starred Michelin Guide restaurants guarantee the diner an excellent meal, four, and five star Morningstar ratings do not provide mutual fund investors with above-average returns.” So use the metaphor of your choice—a caste system with surprising upward mobility, an unreliable Michelin guide, or perhaps a movie critic with poor taste. All add up to the same thing—fund ratings aren’t reliable. According to fund data going back to 1992, the funds rated highest by Morningstar consistently underperformed the Wilshire 5000 stock index, and by a wide margin.
Even Warren Buffett, one of the most oft-quoted advocates of so-called “value investing”—buying shares that are supposedly undervalued by the market—turns out to be a closet efficient-markets guy in his own right. He had this to say in his 1996 annual report: “Most investors, both institutional and individual, will find that the best way to own common stocks (shares) is through an index fund that charges minimal fees. Those following this path are sure to beat the net results (after fees and expenses) of the great majority of investment professionals.” Not the kind of thing you find in those dozens of books that tell you how to invest “the Warren Buffett way.” Seems that Warren wants you to invest “the Burt Malkiel way.”
But, hey, this is a free country. You don’t have to believe that the mutual fund industry is built on a lie, and that its primary economic purpose is to siphon off money from your account to fund a mammoth corporate welfare project. You can just give them your money and hope for the best. Hope for good performance. Hope that your fund manager has lost his copy of Feeling Good.