Chapter 15
On Principles
Important Principles Must Be Inflexible
One hundred and thirty-four years ago, in what proved to be his final public address, Abraham Lincoln said: “Important principles must be inflexible.” He was right. In my judgment, the single most important principle on which the mutual fund industry was founded—and under which it has prospered—not only has become far too flexible, but is apparently being abandoned. This chapter will describe how this process has disengaged us from our roots, propose some solutions, and, along the way, suggest the role that mutual fund shareholders might play in a renaissance that will make this a better industry.
What are the mutual fund industry’s founding principles? Management, diversification, and service (including daily valuation of fund shares, liquidity, full disclosure, and convenience). Of these principles, management is the most important. Fund management, in my view, should be defined by a spirit of trusteeship, professional competence and discipline, and focus on the long term. That vital principle and these three critical components are in the process of losing their role as the driving force—in the long run, the life force—of the mutual fund business.
That is a strong statement, but I consider it a fair description of what is going on in the industry at present:
• Trusteeship implies making the interests of fund shareholders our highest priority and charging a reasonable price for our services. It is being supplanted by a focus on asset gathering—on distribution of fund shares. We seem to worship at the shrine of the Great God Market Share, the exorbitant cost of which is borne by fund shareholders.
• Professional competence and discipline, originally applied to investment fundamentals, are being focused on speculation. The earmarks include rapid turnover in fund investment portfolios (averaging 85 percent per year!), funds’ concentration on ever narrowing segments of the stock market, and far too many gunslinger portfolio managers.
• Focus on the long term, which once defined the eminent suitability of mutual funds for long-term investors, has become a focus on the ownership of fund shares for the short term, a second level of speculation. Even more baneful, fund shareholders are being enticed to use their mutual funds as vehicles for rapid switching—sometimes to take advantage of market timing, but too often to simply jump on the bandwagon of the latest hot fund. That, too, is speculation.
These trends are ominous, for investors as well as for the industry. More important, these trends are hardly good for our nation’s system of capital formation. Sixty years ago, Lord Keynes wrote: “When the capital development of a country becomes the by-product of the activities of a casino, the job is likely to be ill-done.” His warning is equally valid today. The mutual fund industry is developing a form of casino capitalism, featuring rapid trading in the financial markets and in the mutual fund marketplace, with an excessive portion of the amounts that are wagered going to the croupiers. Unfortunately, the terminology of gambling has begun to permeate the world of investing.
TEN YEARS LATER
Important Principles
The trend that I identified a decade ago indeed proved ominous, for investors as well as for the fund industry. Casino capitalism came to sit in the driver’s seat, and trusteeship, professional competence and discipline, and focus on the long term were lost in the shuffle. But the urgent need to return to our industry’s founding principles remains.
Distribution Drives the Industry
In the mutual fund industry, distribution has become more important than management, and asset gathering is superseding trusteeship.
ad My concern regarding these trends is hardly new. When I wrote my 1951 senior thesis at Princeton University, I chose as my topic a tiny young industry that had $2 billion of assets under management—roughly 0.04 percent of today’s $5 trillion total. Even then, I explicitly concluded that funds should give their shareholders a fairer shake by cutting fees and sales charges, and by making “no claim to superiority to the market averages.” More fundamentally, I urged that the focus of the industry should be, above all, on serving shareholders, “the function around which all others are satellite.” At the close of the final chapter of my thesis, I underlined this citation:
“The principal function of investment companies is the management of their investment portfolios. Everything else is incidental to the performance of this function.”If that principle ever existed, it is on the way out today. Distribution of mutual fund shares seems to have become the principal function of investment companies. Listen to the manager of the largest mutual fund: “It’s like the difference between making movies and distributing them. It’s better to be in the distribution business, given that you have access to everybody else’s business.” This is, of course, a plug for the mutual fund casino, the so-called fund marketplace. The idea is: “Buy any funds that catch your fancy, but buy them from us.” Trade often, and, by shifting the cost of trading from your own account to the amorphous, voiceless mass of the longer-term shareholders of the funds, do it “for free.” Today, the average holding period for an equity fund investor appears to be about three years; in 1970, before the days of “free switching,” it was something like 12½ years.
Management versus Distribution
Note how far such a strategy departs from what I regard as the two most basic principles of investing in mutual funds: invest for the long term, and its corollary, don’t expect miracles from management (another quote from my Princeton thesis). What I’ve called casino capitalism is diametrically opposed to those two principles. Paradoxically, the head of by far the largest mutual fund casino (known accurately, but rather sadly, as a “supermarket”) agrees with both of them. His own personal investment principles are evidenced in his actions: He owns funds as long-term investments. In his own words, “in market timing . . . there are so many things working against you . . . the decision making, the emotional part, the analytics of making the right decision . . . the cost, the taxes.” And he owns passively managed index funds. “I’ m more of an indexer . . . if you get an S&P index return, you ll be in the 85th percentile of performance. Why would you screw it up? ” Yet the firm he created seems to be built on two countervailing principles: “Pick hot managers,” and its corollary, “Switch and get rich.” Maybe it is my Calvinist streak, but I am troubled by the idea that one’s personal investment principles can so blatantly contradict the investment principles of one’s business. President Lincoln would not have been amused.
These examples from two of our industry’s current leaders buttress my concern that the industry is on the way to abandoning its fundamental principle—management—and replacing it with another principle—distribution at all costs. Why is this a problem? First, distribution is extremely expensive, and the costs are borne by mutual fund shareholders in the form of ever-rising expense ratios. The annual equity fund expense ratio has risen by some 50 percent in 15 years (from 0.97 percent of assets in 1981 to 1.55 percent in 1997), even as assets have exploded (see
Figure 15.1). With equity fund assets up from $40 billion to
$2.8 trillion, I estimate that annual costs paid by equity fund shareholders alone (taking into account that large funds typically have somewhat lower ratios than small funds) have risen from $320 million to
$34 billion in this period—a hundredfold increase, far larger than the 70-fold increase in equity fund assets. If fund expense ratios in this industry had simply remained fixed, the costs borne by mutual fund investors would at present be $27 billion—a $7 billion saving. And, because there are staggering economies of scale in portfolio management and research, expense ratios should have substantially
declined, and savings should have been enhanced by even more billions.
The second problem with this focus on distribution is that, ordinarily, no significant benefits flow to shareholders as a result of large size; in fact, large size is generally detrimental. Shareholders are paying the piper but are not able to call a better tune. In the real world, higher costs harm shareholders by widening the gap between financial market returns (in effect, market index returns) and the returns earned by market participants. This is patently true of money market funds, where maturity and quality are constrained by federal regulation. It is also profoundly important in high-grade bond funds (consider a short-term U.S. Treasury bond fund, for example), and increasingly obvious in the equity fund arena, where passively managed, low-cost market index funds outpace most actively managed equity funds.
The disjunction of these two trends produces an overwhelming irony: enormous amounts of the expenses paid by fund shareholders are not benefiting those very same shareholders. In effect, high fees are paying for huge profits to fund managers (or their public stockholders, who are just along for the ride), who, as a group, are consistently underperforming the financial markets in which they participate.
This situation has developed largely because of the gradual deterioration of the guiding principle that management is the central function of mutual fund companies—the function around which all others should be satellite. This is not just a question of principle, but of compliance with federal law as set forth in the Investment Company Act of 1940, which clearly states that investment companies must be managed in the interests of their shareholders.
What can be done to reverse these ominous trends? How can fund investors get a fair shake? After preaching this gospel for a long, long time, I’m starting to lose heart about the possibility that mutual fund independent directors—despite being required by law to place the interests of fund shareholders first—will ever try to stem a tide that, truthfully, needs to be reversed. Can we rely on competition to do the job it usually does so well in our economy, but has failed to do in the mutual fund industry? Price competition has proven to be an unlikely product of a roaring bull market where a 16.5 percent annual rate of return for equity funds is the bonus of a lifetime. Never mind that the total stock market’s annual return was 18.9 percent, and that we are not apt, in our lifetime, to see its like again. The lion’s share of the fund shortfall versus the market return was caused by mutual fund costs. In a less generous stock market, with better-informed investors, competition should, finally, carry the day.
For competition to work, however, investors need information before they can develop knowledge, and knowledge before they can develop wisdom, and wisdom before they can develop a commonsense financial plan. There is more than enough information available about the past returns, prospective risks, and actual costs of mutual funds. The problem is that not all of this information is made public. Too often it falls victim to inadequate disclosure, or selective disclosure, or even non-disclosure. And even when information is fully disclosed, it is usually ignored by investors who don’t recognize its importance, or—in today’s exuberant market environment—don’t think it is particularly relevant. Demanding investors—especially if better informed by probing, thoughtful commentators—can play a huge role in forcing the industry to return to its founding principles.
TEN YEARS LATER
Mutual Fund Costs
While the expense ratio of the average equity fund leveled off and then actually declined a bit over the past decade, equity fund expenses (measured in dollars) soared. With average assets of about $5.2 trillion in 2008, total expenses continued their rise, from some $24 billion in 1997 to an estimated $43 billion in 2008.
While I confessed to my losing heart that the rising tide of fund expenses could be stemmed, some encouraging signs have emerged. First, while fund sponsors have made no serious attempts to significantly reduce fees, fund investors are becoming increasingly selective, turning toward low-cost funds—or at least to funds with below-average costs—and away from funds with high costs. In 2005-2007, for example, 93 percent of investors’ net purchases of equity fund shares were directed to funds carrying costs that were below industry norms.
The second major trend is the rising use of index funds by investors. These (usually) ultra-low-cost funds—diversified over the entire stock market and/or bond market or various sectors of each—now account for fully 22 percent of equity fund assets, more than double their 10 percent share of a decade ago. As I noted then, “Demanding investors . . . can play a huge role in forcing the industry to return to its founding principles.” That seems to be what’s happening, though hardly yet in the dimensions that are required.
Information That Can Make a Difference in Your Fund Investments
Let me point out six areas of information in which you, as an investor, can better educate yourself: (1) cost, (2) fee waivers, (3) performance, (4) proxy voting, (5) alternative investment strategies, and (6) investment guidance.
You can profitably use this information in the fund selection process, in the proxy voting process, and in deciding which of your fund holdings might no longer warrant inclusion in your portfolio. “Voting with your feet” is the most effective way to bring about positive change. But if you contemplate redeeming your fund shares, don’t forget to consider their tax cost basis. In these bountiful days of market appreciation, the funds you own are apt to have a bit of a lock on your money.
Cost Information
Cost is just as important to fund investors as risk and return, because excessive cost—other things being equal—either directly reduces return or increases the potential risk assumed to achieve a target return. As discussed in Chapter 3, cost has profound implications for asset allocation strategy, the most critical decision an investor faces. A high-cost portfolio must have a significantly higher stock position and a lower bond position to generate a return equal to that of a low-cost portfolio. This is a message that you must always bear in mind.
Thanks to a vigilant Securities and Exchange Commission (SEC), fund prospectuses now do an adequate job of showing the impact of expense ratios and sales charges. They show the actual costs of both, as well as hypothetical illustrations of their combined impact on the returns earned by mutual fund investors who hold their shares for periods of one, three, five, and ten years. Indeed, the SEC has just upped the ante. The old standard of cost disclosure was based on an exceedingly modest $1,000 investment, so the 10-year cost of, say, $185 for owning an average fund looked trivial. Now the disclosure standard is based on a $10,000 investment, and the cost is $1,850. An investor—at least one who looks at the prospectus—just might decide that is a pretty large bite. In any event, over 10 years, costs would consume fully 18.5 percent of that initial fund investment—a clear and compelling piece of information. For a very low-cost fund, it might be only $200, or 2 percent of $10,000—and that represents a striking difference from $1,850. I recommended this change to the SEC a few years ago, and I ’m delighted that it is now in place. It will help investors to focus on the critical factor of cost. But the other heavy cost of fund ownership is not disclosed: the transaction costs that the fund incurs in the turnover of its portfolio. The costs can be only vaguely inferred from the turnover figure itself, which is reported in the prospectus. But the indirect cost of turnover often rivals the direct fund costs that are disclosed. Funds ought to be required to estimate them and disclose them in their prospectuses.
I have also urged—so far, without success—that a comparison of a fund’s expense ratio with that of its peer group be required in the annual report. Over extended periods, costs often make the difference between top-quartile (or, for that matter, bottom-quartile) returns and average returns. But today, in a typical annual report, it is difficult to find even the one mandatory reference to a fund’s expense ratio. (Hint: Look for it at the end of the report, on a single line buried deep within a 14-line table of “Financial Highlights,” right before the ever-scintillating “Notes to Financial Statements” and the “Report of Independent Accountants.”) The SEC even asks for more than that in the prospectus; witness the 10-year cost table I mentioned earlier. Investors should urge funds to give increased prominence to costs, and to discuss their impact on returns. Investors also deserve information about the tremendous portion of fund income that is consumed by costs. Currently, costs reduce the income yield of the average equity fund by fully 75 percent—from gross income of 1.9 percent to net income (after the deduction of expenses) of less than 0.5 percent—a yield that is clearly a pittance. Yet the percentage reduction in income is not even disclosed.
Fee Waiver Information
Don’t take only my word for the fact that costs are important. The fund industry knows it, and a few lower-cost funds designed for high-net-worth investors even feel compelled to advertise that “other factors held equal, lower costs lead to higher returns.” When costs are used as a marketing weapon within the industry, we see, not true cost reductions that benefit fund shareholders, but teaser rates in the yields on money market funds, for example, accomplished by fee waivers and expense absorptions for “a temporary [and unspecified] period of time.” Such cost reductions are designed to mislead shareholders about a money market fund’s sustainable yield. How can it be proper to annualize a money market yield that may endure for only one day after an advertisement appears? Make no mistake: costs are essentially the sole determinant of relative yields on money market funds, and investors care about those yields.
Consider this example: One money market fund grew, within less than two years of its inception in 1989, from $100,000 to $9 billion in 1990 by temporarily waiving fees. Then, the adviser reinstated the full, typically onerous, fees without having the courtesy to notify the shareholders. The fund’s assets gradually dwindled to $1.6 billion. Smart investors obviously fled the fund as they gradually experienced the yield reduction firsthand, but many less observant investors remain in the fund. It is a sad commentary on the relationship of marketing (it worked) to management (it failed).
Investors should seek realistic information that shows a fund’s true yield after the deduction of all expected costs, and should generally ignore the teaser rate created by the fee waiver. Funds should no longer be permitted to publish yields that are subsidized, unless the subsidy has been guaranteed for, say, at least three years. The same approach should be taken with index funds that temporarily provide low expenses in order to appear competitive in the marketplace. (One of the largest S&P 500 index funds, waiving fees so as to appear as the lowest-expense such fund, openly acknowledges to the trade press that it does not expect to remain in that enviable position after its subsidy expires. Interestingly, however, the prospectus makes no such disclosure to investors.) Arguably, investors should consider taking advantage of these low rates while they last. Doing so, of course, requires considerable vigilance thereafter, in order to observe when the fee waiver terminates. Discouragingly, the clear duty to notify shareholders of this event is ignored by fund sponsors.
Performance Information
Within the fund industry, it is no secret that the conventional rates of return to measure a fund’s performance (time-weighted, on a per-share basis), with few exceptions, reflect performance that is significantly higher, and in many cases radically higher, than the returns actually earned by its shareholders (dollar-weighted, on the basis of total net assets). The present conventional measure is simple, convenient, and useful, but it doesn’t tell the whole story. How relevant is this measure for a fund that begins a period with, say, $50 million in assets and ends with $3 billion? Is it easier to manage, or even, heaven forbid, to manipulate a small fund’s portfolio? Can even a manager who is not playing games in the initial public offering (IPO) market sustain his or her success when the fund being managed is 60 times as large?
The answers to these questions are not without significance to investors. For whatever reason, the fund with the highest (conventionally measured) return in the entire industry—annually, about 20 percent per share—in the decade ended July 31, 1996, had a dollar-weighted return of -4 percent during that same period. There is a difference, and investors should be aware of it. Urge your fund to report dollar - weighted returns, along with time-weighted returns, in its prospectuses and annual report.
aeIn this context, you are entitled to a clear explanation of the fund’s early performance before you invest. Its manager is apt to be tight-lipped on the subject, but there is usually an important story that ought to be told. For example, during 1995, the 10 top-ranking general equity funds—all quite new, and with, on average, less than $100 million of assets—rose 67 percent, more than double the 31 percent gain for the average general equity fund. How? Twenty 5 percent positions, each of which rose 67 percent? Inconceivable. Twenty positions—four up 180 percent, and the other 16 up 39 percent on average? Possible, but unlikely. Eighty positions, because the 20-stock portfolio had an average holding period of three months? Most likely of all. No wise observer would expect these funds to outpace the market by three times over again. And they didn’t. Their average gain was 5.9 percent in 1996 and 5.6 percent in 1997, which put them 25 percent below the total stock market for the full three-year period. Less seasoned observers, who base their investment decisions on past performance, could have been warned of the peril if they had had information about the nature of those surprisingly large returns.
You are also entitled to better risk disclosure, although it is easier to state the obvious need than to fulfill it. Risk is a highly complex issue, and I believe that the central issue is a fund’s specific risk relative to the total stock market. Most investors are generally aware of the nature (if not the dimension) of
stock market risk, so we should focus on the second and third elements of risk:
objective risk (large-cap value versus small-cap growth, for example) and
manager risk (how good is the fund adviser within its objective group?). While manager risk is unpredictable, objective risk remains remarkably consistent over time. Both elements are nicely subsumed by a simple comparison of a fund’s total quarterly return with that of a broad market index.
Figure 15.2 displays the two returns and shows the general nature of a fund’s risk tolerance (or intolerance). In a large-cap index fund, the bars in the chart would be almost identical; in a small-cap aggressive growth fund, they would be quite different. Emphasizing that relative risk is more predictable than future return, I recommended that such a chart be included in fund prospectuses. While it did not adopt that suggestion, the SEC did add a requirement that a fund disclose the highest return and the lowest return it earned in any quarter during the prior decade. This disclosure is a big step forward, but it would have been far more useful to have also shown the stock market returns during each of these quarters, in order to indicate whether the fund is taking more or less risk than the investor wishes to assume.
TEN YEARS LATER
Performance Information
Of course I’m pleased that my early call for the reporting of the returns actually earned by mutual fund investors (dollar- weighted returns) as well as the conventional returns reported by the funds themselves (time-weighted returns) has at last been answered. While (to my knowledge) no mutual fund has yet reported on the returns that it actually earned for its investors, Morningstar now regularly reports both sets of data.
To understand why funds still duck such disclosure, we need only look at the data. As I discussed in Chapter 11, among the 200 largest mutual funds during the decade ended as 2000 began, the 6.5 percent annual return earned by fund investors was 3.3 percent behind the 9.8 percent annual return reported by the funds themselves. (Cumulative return for funds was + 152 percent; for investors, +88 percent.) These figures clearly confirm what I believed a decade ago: “the conventional rates of return [we rely on] to measure a fund’s performance . . . reflect performance that is higher, and in many cases radically higher, than the returns actually earned by its shareholders.” As this valuable information works its way into the minds of investors, their own returns will be enriched.
FIGURE 15.2 Risk Measure: Contrasting Quarterly Returns (1988-2008)
Proxy Voting Information
Too few mutual fund investors take the trouble to read the proxy statements disseminated by their funds. These statements rarely highlight proposals that shareholders approve an increase in advisory fees, and never publicize them. The media generally receive releases that brag about performance, or a star manager, or record cash flows, rather than releases that discuss matters that the fund’s managers hope will remain hidden from shareholders. Managers know that if investors are better informed, they are more likely to “just say no,” or to “vote with their feet” and redeem their shares. The only way to avail yourself of this opportunity is to pay careful attention to your fund’s proxy, even though it is rife with tortuous prose. If you merely vote in your own interests as a shareholder, the mutual fund industry’s wanton tendency to increase advisory fees and add distribution fees will be curbed.
Given the inattention of shareholders—or perhaps their confidence that the directors of the fund will protect their interests—abuse occurs. Operating behind a veil of public ignorance, for example, a major fund complex was able, within the space of a year, to raise its fees by 100 percent. First, in December 1991, fund shareholders were sent proxies requesting approval of a new investment advisory fee contract that would raise fees by 50 percent. The base fee would increase by 25 basis points, from 0.50 percent of assets to 0.75 percent. The reasons cited were the increased cost and complexity of investment management and research activities, and the fact that the fund’s fees were (heaven forbid!) “below average.” Not disclosed—a serious lack of disclosure, in my view—was the effect of the fee increase on the pretax profits of the adviser, which likely rose by as much as 100 percent. Shareholders duly approved the proposed increase.
Armed with this surge in profitability, only seven months later (this may not surprise you), the adviser sold itself—for a cool $1 billion—to one of its competitors. It then asked the fund’s shareholders to approve not only the change in control, but another 0.25 percent fee increase—this time, a 12b-1 distribution fee in that amount. Another surge in profitability for the adviser (and its new owner) surely followed, presumably adding considerable value to the price that had been agreed on for the sale. The new fee raised the expense ratio to 1.19 percent, or about 60 percent above the 0.75 percent level at which it had reposed less than a year earlier. (With asset growth, the annualized fees paid to the adviser then rose from some $45 million to $100 million, or 125 percent.) Nonetheless, the fund directors had reviewed the proposal, as they are obliged to do under the law, and found that this new fee, as part of the merger package, imposed “no unfair burden” on the fund. Presumably impressed by this endorsement by the fund’s ostensibly independent directors, and uninformed about the additional, larger increase in the adviser’s profits, shareholders again dutifully approved the fee increase.
This brief anecdote provides in microcosm a two-step process that is far from rare in the fund industry: Increase the fees paid for management, without any specific disclosure about how much, if any, of the revenues might be dedicated to additional portfolio supervision and research expenditures and how much to marketing expenses and to the adviser’s profits; and add further distribution fees (because the sales of the fund’s shares potentially could increase, as compensation to dealers becomes more attractive), without disclosing the fact that higher sales volumes hold absolutely no benefit to shareholders. If there is a better example of the clash of the cultures—management versus distribution—I’d be hard-pressed to find it. Fund advisers ought to be required to disclose their revenues, expenditures (showing management, marketing, and administrative costs separately), and the profits they earn from each fund they manage, and from the funds as a group.
Imagine the reaction of consumers if a Big Three automaker increased the average price of its new cars by 60 percent—from, say, $16,000 to $26,000. This would never happen in the competitive automobile marketplace, where there is real price competition, but it does happen, time and again, in the mutual fund marketplace, where such competition is conspicuous only by its absence. The advisory fees paid by a fund are not set by the market, but normally recommended to the fund board by the agreement of the fund president and the president of the investment adviser, who are usually the same person. (Now that is a tough scenario for arm’s-length negotiation!) Shareholders owe it to themselves to pay at least as much attention to the prices they pay for their funds as to the prices they pay for their cars.
TEN YEARS LATER
Proxy Voting Information
While few fund managers yet disclose the sources of their revenues and the allocation of their expenses to, for example, portfolio management versus marketing, to say nothing of their own profitability, a hopeful sign recently appeared about the possibility that free competition (to lower fees, that is) may at last confront the mutual fund industry.
The U.S. Supreme Court has agreed to hear arguments (scheduled for November 2, 2009) that the industry’s fee- setting practices are flawed. These practices largely rely on comparisons of one fund’s fee rates—not dollars—to another’s (a similar, and equally flawed, practice that has been importantly responsible for many of the gross excesses we’ve seen in the compensation of corporate chief executives, where the standard is set by the pay of peers, not by corporate performance). If the Supreme Court holds that these practices are a violation of the fiduciary duty regarding fees that is set forth in the Investment Company Act of 1940, competition should, at long last, result in lower costs to fund investors.
Information about Alternative Investment Strategies
The mutual fund industry has been built, in a sense, on witchcraft. Enchanted by a long bull market and the conventional (but illusory) notion that “the pros”—and especially “hot managers”—can do better than mere mortals, investors are ignoring the drumbeat theme of experience: Fund net returns, sooner or later, revert to the market mean and finally below it. Investors owe it to themselves to be aware that traditionally managed mutual funds are not the only way to invest. Holding individual stocks for the long term may not only be wise, but be far more tax-efficient. And market index funds are also a promising, if counterintuitive, choice. The record is clear that a low-cost index fund has provided enhanced returns for long-term investors. Our prominent casino man, quoted earlier, said that it will provide returns better than 85 percent of all stock funds (“Why would you screw it up?”).
I know that index funds are boring. They aren’t sexy; they don’t make news; their managers, if never morons, are rarely geniuses; they don’t “beat the market.” It is ironic that it is only in recent years that the index funds (after more than two decades of operating experience) have received the attention they deserve. That recognition, sadly, is based more on the truly sensational results of the S&P 500 Index during the past three years (top 6 percent of funds, almost certainly unrepeatable in any future three-year period) than on its outstanding long-term record. Index funds are now hot, but that’s a silly reason to invest in them. It is high time to focus not on their short-term performance, but on their principles. It is also time to focus on not merely index funds, but low-cost index funds. Low cost, broad diversification, and tax efficiency are virtually the only essential merits of this passive management strategy. Some 40 index funds have sales charges, and 25 others have expense ratios of 1 percent or more. As William Safire would say, “Fugeddaboudit.”
Investment Guidance Information
No matter how much—or how little—you agree with me on the long-run impact of reversion of fund performance to the mean, and the role of cost in performance, you ultimately want advice about which funds you should own. For too many investors, the choice comes down to which funds they believe will provide the highest future return. Investors don’t consider the role of cost or the rule of reversion to the mean, but usually look solely to the past track record. They are led in this direction by publications that lionize the latest superstar manager or publish lists of the best mutual funds for the next decade (or even the next year, or even an unspecified period). But investors would be well served if publications accepted the obligation to critique, in retrospect, their own performance with the same doggedness that they critique fund performance. “Sauce for the goose is sauce for the gander.” Disclosure of how funds on recommended lists performed after their appearance would surely make investors skeptical about the foresight of such lists. Whether from the media or the funds themselves, intelligent investors should demand accountability.
One biweekly national magazine has produced an honor roll of funds each year, and has been doing so for roughly a quarter century. Its honor roll funds, on average, have produced a rate of return of +12.5 percent per year since 1973, compared to +14.7 percent for the Wilshire 5000 Index, which outpaced the honor roll fund average in 14 of the past 15 years. What is more, the honor roll funds seemed to carry a bit more risk than the Wilshire 5000 Index, declining more than the index in all four down-market years during the 24-year period. Why shouldn’t the magazine report these facts to its readers each year, as it updates its statistics and adds and deletes funds from the roll?
A monthly national magazine, in a recent article, published the results of its “picks from the past,” but did not compare them with a market index, nor present a cumulative average return for its 10 picks. It did inform readers: “We’ re reasonably content with our picks.” One can only imagine why they should be. Their list produced a two-year return of 14.7 percent, only about two-thirds of the 20.1 percent annual gain in the Index for the same period. Would any investor be “reasonably content” with such performance? Why? Investors deserve full disclosure from those who purport to purvey investment guidance to them.
Esperanto-Type Cranks
I return here to my central theme: If you agree with my thesis, you can help yourself by seeking full disclosure about fund costs, fee increases, performance and risk, alternative investment strategies, and fund guidance, important information that will help you to soundly evaluate mutual funds. By doing so, you can help redress the imbalance that is increasingly tilted in favor of fund distribution at the expense of fund management. I believe, profoundly, that returning to our first principles will provide bountiful benefits to mutual fund shareholders.
Let me expand on this theme with a parallel of politics and mutual funds. I turn to Esperanto: “a language of supreme universality.” According to
New Yorker political correspondent Michael Kelly, an Esperantist is “sort of a unified-field theorist, a believer in the
one great idea that will fix anything, an overarching concept that puts it all into context.”
1Mr. Kelly cites 1996 vice presidential candidates Jack Kemp and Al Gore as “Esperanto-type cranks—men who, if they may not have ambitious intellects, have the ambition to be men of ambitious intellects.” Jack Kemp, Kelly writes, is “a glory of capitalism man, believing that if the money machine can ever be built just right and oiled just so, it will drive the world forever in humming happiness.” Al Gore is described as “a believer in systemology—that everything is connected to everything else, holistically, and that fixing it all is just a matter of getting all the systems running right, beginning with one’s own and working outward from there.” Kelly concludes: “The driving dream of every Esperanto-type crank is that if he could only explain things to enough people carefully enough, thoroughly enough, thoughtfully enough—why, eventually everyone would see, and then everything would be fixed.”
Had he been considering mutual funds rather than politics, Mr. Kelly could easily have described my strong and simple beliefs in a similar fashion. Please do not mark me as just another Esperanto-type crank, but carefully consider my driving dream that most of this industry’s shortcomings would be fixed if we returned to our first principles: focus on management, not distribution; on professional competence and discipline, not gunslinging and speculation in casinos; on trusteeship and adding value through low costs, not asset gathering and dissipating value with exorbitant costs.
This change will happen—and this is the “one great idea”—only if we move to a system in which the focus of mutual fund governance and control is shifted. Today, it almost invariably reposes with the executives and owners of mutual fund management companies, who seek good fund performance, to be sure, but also seek enormous personal gain, and seem incapable of successfully balancing the obvious direct conflict in apportioning the two. It is imperative that this conflict be resolved. Mutual funds must be operated under the enlightened governance of directors who are responsible solely to the shareholders of the mutual funds themselves, for whom fund performance is the sole measure of profit.
In recent years, the principles of management—including trusteeship, professional competence and discipline, and focus on the long term—have been compromised by the demand for distribution and asset gathering above all else, and their return to preeminence seems a long way beyond the horizon. But tomorrow is another matter, and now that I’ve explained it to you, I hope, “carefully enough, thoroughly enough, thoughtfully enough—why, eventually everyone [will] see, and then everything [will] be fixed,” as Michael Kelly wrote. As Thomas Paine stated so eloquently, “A thing moderately good is not so good as it ought to be. Moderation in temper is always a virtue; but moderation in principle is always a vice.” The kindest thing that can be said about mutual fund principles is that they have been “moderated.” Now is the time to demand that the important and traditional principles of this industry must be inflexible. If investors demand change, their interests will be served.
TEN YEARS LATER
Esperanto-Type Cranks
I continue to stand behind each and every principle of fund management that I stood for a decade ago, even as I’ m disappointed that these principles continue to be honored more in the breach than in the observance by far too many fund managers. I also stand behind the importance of all six points of information that I called for at the same time, even as I’m pleased to report on the progress that has been made in getting that information out in the open, helping investors to make better decisions in their own self-interest.
And if I were an Esperanto-type crank then, I’m even more of one now. For my driving dream remains: If only I could explain things to enough people carefully enough, thoroughly enough, thoughtfully enough—why, eventually everyone would see, and then everything would be fixed. Yes, investors will finally see, and yes, one day, everything will be fixed.
