Consider this very recent example. An article in Morningstar Investor¹ presented, deadpan, recommendations by an investment adviser for a married couple investing $350,000, with retirement only five years away. He recommended a portfolio, almost entirely in equities, of 17 mostly small-cap and international funds. We can predict, I think, a high likelihood that the total of 2,000 individual stocks in the 17-fund portfolio will produce at best a market return before expenses. After fund expenses averaging a rather robust 1.6 percent of assets, the trading costs of funds with a 92 percent average annual portfolio turnover, and the adviser’s fee of 1 percent—let’s call it an all-in cost of 3.5 percent, or $12,250 per year—it would seem inconceivable that the couple will be very happy with the outcome when their retirement comes. They will have paid a significant percentage of their returns to both the adviser and the mutual fund management companies for their putative investment expertise. In return, they will receive, at best, a market return—before costs. Does there really seem to be much chance of outperforming the market with a 2,000-stock portfolio that, for all intents and purposes, is the market?

TEN YEARS LATER

Funds as Stocks

With the exponential growth of the availability of stock prices and fund prices (and all other financial data) on the Internet, the New York Times now publishes only an extremely limited list of daily stock prices, and an even smaller (and spasmodic) list of fund prices. But the idea of treating funds as stocks has exploded, with exchange-traded funds (ETFs) now traded at rates far higher than the turnover of individual stocks themselves. Whereas stocks listed on the New York Stock Exchange averaged an annualized turnover rate of 155 percent during the first half of 2009, ETF turnover averaged a truly incredible 3,000 percent. I ’m crestfallen that my concern that aggressive trading and rank speculation in fund shares would become even more akin to trading stocks proved so accurate. In fact, trading in funds has now overwhelmed trading in stocks. Paradoxically, most of the fund trading takes place (through ETFs) in index funds, originally designed for long-term investors.

And what of that couple whose adviser recommended in 1997 that they get more aggressive and invest in a portfolio of 17 (largely high-cost) equity funds and eliminate their 30 percent holdings of bond funds and cash in order to reach their goal of an annual return of at least 10 percent? I described it as “inconceivable that the couple will be very happy with the outcome.” As it turned out, that warning appears prescient. Of the 17 funds in the recommended portfolio, fully eight—nearly half !—went out of business in the years that followed, and only nine survived. While some of the survivors did outpace the Standard & Poor’s 500 Index during the subsequent period, we’ll never know how the eight funds that failed would have performed had they survived (though we can assume that they would have performed badly). It’s hard to describe a 17-equity fund portfolio as other than “a stock picker’s portfolio.” I’ m confident that this is hardly the only case where such a strategy proved hazardous to the wealth of investors.

The trend that is turning funds into stocks has been gradual, but I like to mark a particular date when the conversion became clear to me: March 19, 1995. This date, if it hardly will live in infamy, serves as my landmark. On that Sunday, the editors of the New York Times moved the mutual fund price and performance listings ahead of the New York Stock Exchange price quotations. New York Stock Exchange prices had been first in line for the attention of Times readers since time immemorial—certainly for more than a century—but, from that day on, the Big Board would play second fiddle to the upstart nouveau riche mutual fund colossus.

Investment Technology—Bigger, Quicker, and More Complex

How did this transition come to pass? Let’s begin with investment technology and the financial market system. Consider some of the instruments we have today that would have barely been conceivable—and certainly would not have reached the breadth of their usage and the depth of their liquidity—without the computer:

• Something like $20 trillion in notional value of derivatives outstanding.

• An estimated $1.5 trillion traded each day in world currency markets.

• A vibrant market in financial futures, including a notional value of nearly $200 billion in futures for the Standard & Poor’s 500 Index, updated in real time.

• Market indexes (of which we recently counted more than 3,000!), and, thus, index funds.

• Enormous market volumes, with, on busy days, some 1 billion shares of stock trading on the New York Stock Exchange, and another 1 billion shares on the NASDAQ. In all, $30 billion worth of shares changing hands each day.

Amid this feverish trading, the mutual fund industry has developed sophisticated investment techniques that are aggressive beyond anything we might have imagined 15 years ago. We have micro-cap funds; quantitatively managed funds; funds based on theories of price momentum, earnings expectations, technical readings of the market, and multiple regressions that, dare I say, boggle the mind; funds based on adjustable-rate mortgages, covered call options, and foreign currencies; and funds for stocks in Vietnam and Indonesia and the Czech Republic—not hitherto known as bastions of capitalism. Many old-line funds follow strategies that only yesterday would have been deemed outrageous. On average, mutual fund managers turned over their portfolios at a 15 percent rate in the 1950s and 1960s. Even in the go-go years of 1965 to 1968, the rate rose only to 40 percent. But in 1997, the average turnover rate was 85 percent, suggesting that the average holding period for a given stock is now but a hair over one year. Whatever happened to long-term investing by professional managers? By anyone?

As professional and individual investors alike have become aggressive traders who vigorously use today’s computer-driven financial system and the liquidity it has created, mutual funds—once considered long-term investments—have become, to an important degree, short-term speculative vehicles. Many of the former shepherds of the flock have become the sheep of the pasture: a roaming, inconsistent, wild lot, given to impulsive—if sometimes precisely quantified—decisions that frustrate the very purpose of investing on the basis of traditional standards of corporate valuation. We have investment technology to thank for enabling us to engage in all of this feverish activity. But technology has given us the tools without giving us the wisdom to handle them constructively.

TEN YEARS LATER

Investment Technology

My earlier concerns about derivative instruments have been borne out—and then some. The notional value of derivatives soared from $20 trillion in 1998 to nearly $600 trillion in 2008, battering the world’s financial markets (and economies) as their enormous risks inevitably came home to roost. Bigger, quicker, and more complex, yes, but also the Achilles’ heel of the financial markets. Institutional investors have not only lacked the wisdom to handle these complex derivatives constructively, but have relied on risk measurements that proved to be profoundly flawed.

Information Technology—Information versus Wisdom

The computer and the Internet have given us nonstop access to data that allow us to analyze and evaluate mutual funds beyond our wildest dreams, and to make fund selections with unimaginably vast information literally at our fingertips. Never again will mutual fund investors lack the ability to make fully informed investment decisions. Mutual fund investors should be among the greatest beneficiaries of the computer revolution.

Perhaps so, but they are also among its greatest victims. Every day, as in the example of investment behavior described at the outset of this chapter, mutual fund investors are proving (as we must have known all along) that, in investing, information is all too often mistaken for knowledge, and knowledge is all too seldom translated into wisdom. But, wisdom, far more than mountains of detailed data, and common sense, far more than opportunism, are ever destined to be the prime ingredients of long-term investment success.

Communications technology has given us immediate access to abundant information when we are considering our fund decisions—to buy, to hold, to add or subtract, to withdraw entirely. How much information? Even today’s garden-variety computer and communications technology takes you to Morningstar’s web site or puts its Principia database on your computer in just seconds. Open the Principia program, for example, click on the name of one particularly large, established balanced fund, and then click on “print.” Out will come 37 (count ’em) pages of statistics and charts:

• The stock portfolio: ratios of price to earnings and book value, earnings growth, market capitalization, industry diversification.

• The bond portfolio: maturity, credit quality, coupon.

• The whole portfolio: turnover, top 25 holdings, and total issues.

• Risk: R-squareds, betas, alphas, standard deviations, Sharpe ratios.

• Return: performance over 25 years, monthly and rolling three months, rankings versus index and versus objective group, tax - adjusted returns.

• Investment style (for each year!): nine boxes for stocks, nine for bonds.

• Cost: sales charges, 12b-1 fees, expense ratio comparisons. (Don’t ignore costs!)

• The concluding summum bonum: the number of stars earned. (Happily, our subject balanced fund rates four stars.)

It is no exaggeration to say that the superb Morningstar service provides all the information an investor could possibly need to evaluate a fund’s characteristics, to understand a fund’s persona, and to make informed decisions. Indeed, I think it is fair to say that the portfolio managers of many funds could not score more than a gentleman’s C on a test given by an investor holding the Principia printout, presumably there to give the investor an edge in making investment choices.

Investors who rely on this information, I fear, rarely use it for much knowledge beyond the fund’s performance and star rating. Rather, trust is placed “in our stars, not in ourselves” (the opposite of what Cassius told Brutus). Some 85 percent of the $160 billion that flowed into equity mutual funds in 1997 went into funds with five-star or four-star ratings, and only 15 percent to the one-, two-, or three-star funds. (Perhaps ominously, another $60 billion flowed into untested funds, often with hot records, that had not yet received ratings. They had not reached the ancient vintage that is used to establish a manager’s bona fides: just three years—and during a booming time period at that.)

Knowledge, provided it is translated into wisdom, is indeed power. But information and trusting in the “stars” will not give investors the power to enhance their returns unless they use that information wisely. In short, although the Morningstar web site and software are priceless for understanding a fund’s investment style, past returns, and present portfolio, the evidence strongly suggests that it is virtually worthless in enabling investors to pick the future top performers. Technology has made information accessible without providing knowledge and without engendering wisdom. Perhaps a rereading of Proverbs would remind us of what is really important: “Get wisdom, get insight.”

Transaction Technology—Switch When the Iron Is Hot

Transaction technology has given us the ability to trade funds beyond our wildest imaginations, as unambiguously unhelpful as it is to fund investors and to the portfolio managers of the funds whose shares they trade. And investors do use that ability. Turnover of equity fund shares by mutual fund investors has soared. In the 1960s and 1970s, redemptions (and their twin, exchanges out) of equity fund shares averaged 9 percent of assets per year; in the 1990s, the rate has more than tripled, to 31 percent. Fund investors appear to change their investment managers and their holdings of individual stocks with almost equal rapidity.

Using the reciprocal of these numbers as a proxy for the average number of years that equity fund shares are held (and it is a pretty good proxy), the holding period has tumbled from 11 years in the 1960s and 1970s to slightly more than three years in the 1990s. Just three years.^ag This trend, in my view, has emasculated the purpose of the best long - term investment medium ever devised: the broadly diversified, soundly managed, efficiently operated mutual fund. Whatever happened to long-term investing by mutual fund shareholders? The greatest investor of our time, Warren Buffett, buys and holds, and describes his strategy to the world in his annual reports. Yet we ignore his sage advice.

Perhaps the apotheosis of the confluence of investment technology, information technology, and transaction technology is found in the great fund casino—the no-transaction-fee mutual fund marketplace in which funds can buy a computer billboard that enables shareholders to turn their shares over rapidly and without apparent commissions. The costs of the system are hidden from view. First, all of the shareholders pay for access that is used, in most cases, by a small minority of them. An annual fee of about 35 basis points is paid by the funds to the casino that holds the assets of the funds. Second, all of the shareholders are burdened by the costs the fund incurs when portfolio transactions are necessitated by the inflows and outflows of capital engendered by the minority. Sensitivity to fluctuations in the stock market is substantially higher among fund shareholders playing in the casino than among other shareholders (although, as my earlier turnover figures suggest, that is quite high enough).

At least a few others share my concern about the role of technology in the world of investing, and about the accelerating pace of investors’ turnover of fund shares. A recent New Yorker article described it in harsh terms: “. . . giddy money managers [including, I would add, investors who actively manage their own fund portfolios] are enthralled by the new gadgetry—the technology now sits at the center of a speculative frenzy of religious intensity, a financial mania, a bubble.”²

That may seem a strong condemnation, but there is some truth in it. Nonetheless, I freely concede that technology has served fund shareholders extremely well in one sense: The unit costs of fund share transactions and fund portfolio transactions have sharply declined. Indeed, their decline has already helped to reduce the costs of operating mutual funds. Computer costs have plummeted by almost 99 percent, from $150,000 per million instructions per second (MIPS) in 1985 to less than $2,000 per MIPS in 1998. The cost of a personal telephone response was $10 in 1985; today, it is only $2 for an automated telephone response (a bit discomforting for many investors). When a printed fund prospectus is delivered, the cost is $8; when the same prospectus is delivered over the Internet, it costs less than $1. Fund transactions can be electronically implemented and processed by pushing just a few keys on a personal computer—a further huge savings.

It was recently estimated that some 20 million of 50 million fund investors have home computers, with 10 million using them in investing. (Another estimate suggests that 30 percent of the shareholders in the largest casino already handle their transactions on its web site.) Today’s 10 million users will soon become 15 million and then 20 million, and they will all have the ability to redeem their shares at a moment’s notice. It takes only a moment’s contemplation to imagine what might happen in the financial markets if, say, half of that number responded to a major earth-shaking (literally or figuratively) news event. The industry’s old gatekeeper—a busy signal on the telephone—is retiring, for better or worse. Perhaps busy Internet service provider numbers, or even an Internet crash, will “protect” us. Honestly, it’s sort of scary.

As useful and cost-efficient as most of the investor services provided by mutual funds are, the savings engendered by the declining cost of technology have largely benefited fund managers, and, only rarely, fund shareholders. Indeed, the industry alleges that new services have increased costs rather than reduced them. But the new services are often marketing services that are designed to attract investors and their dollars, increase advisory fees and record-keeping fees, and escalate the profits earned by the fund’s management company.

Little solid information is available on the extent of the decline in the cost of communication and transaction services because fund managers rarely disclose how they spend the fees they receive. But one very large mutual fund firm, operating on an “at-cost” basis, has reduced its aggregate unit expenditures on shareholder services by more than 50 percent—from nearly 20 basis points of assets 15 years ago to less than 10 basis points in 1998—a current annual saving of $400 million for its shareholders. In fairness, the fund assets the firm manages have grown some 20-fold, and these economies of scale were passed along to its fund shareholders. A $100 billion fund complex that accomplished a similar feat might have reduced a $200 million cost to $100 million—but does not pass those savings on to shareholders.

TEN YEARS LATER

Transaction Technology

We now know that the concerns expressed in that New Yorker article cited on the previous page were right on the mark. A decade ago, technology was indeed “at the center of a speculative frenzy of religious intensity, a financial mania, a bubble.” That earlier “new economy” bubble in technology stocks burst in 2000-2002, and was heavily responsible for the 50 percent decline in the overall stock market. Little did we know then that we would soon face another “speculative frenzy of religious intensity, a financial mania, a bubble” of even larger proportions that would itself burst in 2007-2009. This time it was also in part technology-based, numbers-crunching technology that allowed the pooling of mortgages into collateralized debt obligations (CDOs), securitization, speculation in real estate, mort gages of dubious (or even fraudulent) quality, ratings agency failure, insuring financial instruments without adequate reserves, and so on. And that later bubble burst was even worse than its predecessor—a 57 percent decline in stock prices, the largest decline since the Great Depression. With the nice market recovery since March 2009, the worst now seems to be over. I hope so, but I would still keep some powder dry ... just in case.

With respect to fund portfolio turnover, technology has also reduced costs—but likely only unit costs. If the cost of trading stocks drops by 50 percent, for example, and the rate of turnover triples (as it has), the total costs borne by fund shareholders will have increased by 50 percent. But again, the fund shareholders, not the managers, are paying the freight—without any evidence whatsoever that all of this feverish activity enhances the net returns they receive.

The Report Card

Let’s grade each aspect of the technologies currently used in mutual fund investing:

• Investment technology: Innovative financial instruments, A+; liquidity, A+; cornucopia of funds, A+; soundness of new funds, C; investment behavior of managers, D.

• Information technology: Availability of data to investors, A+; completeness and scope, A+; availability of meaningful knowledge, A; effective use of that knowledge, D; intelligent selection of funds for future performance, D; investment behavior of shareholders, E.

• Transaction technology: Ease and facility, A+; implicit encouragement to trade funds, A+; efficiency and expense savings, A+; flow-through of lowered costs to fund shareholders, F; facilitation of enhanced shareholder returns, F.

Our report card would rate the contribution of technology to information as A+; to knowledge, C; and to wisdom, D or perhaps even E. In all, good grades go to the technology, bad grades to the users.

What does the technology revolution portend for tomorrow? More web sites, more bulletin boards. More information, more transactions, still more facilitation and speed, and more cost savings (though probably not to the benefit of shareholders). And, I must add, more risk. Most of the new financial instruments made possible by the computer power of technology have never been tested in the crucible of a bear market. Nor have most fund shareholders, who are now able to trade without restraint. And, given the Internet, they can do so without even the intercession that used to be represented—for better or worse—by the inability of funds to staff enough telephone lines. Anyone who is not cognizant of these risks is making, in my view, a serious mistake.

But I am not an aging Luddite who is renouncing the future and calling for a return to the past. We can’t go home again, but I do hope we will soon return to the fundamental principle that mutual funds are best used as long-term investments. I ’m enough of an idealist to be confident that the kind of casino capitalism that is in the air today will not be a permanent fixture in the mutual fund industry. For trading in fund shares not only places roadblocks in the way of the implementation of fund strategy, but it also engenders additional costs to all of the shareholders in the fund. What is more, it is also a loser’s game for fund shareholders who elect to follow active trading strategies. Technology, for all its gee-whiz wonder, is both a bane and a blessing.

The Pervasive Impact of Technology

This dichotomy is found in other fields as well. Consider medicine: Dr. Bernard Lown, the brilliant cardiologist whose healing powers helped to keep me alive from 1967 until I received a heart transplant in 1996 (now there is a miracle of medical science) recently observed: “Medicine depends profoundly on science, but it is not a science”; the medical establishment “has made a Faustian bargain with technology. What is lubricating it is greed. We have created a system that is bizarre.” Ditto for the mutual fund industry.

Best-selling author Michael Crichton has tackled the information technology revolution in the gamut of fields from A to Z—from air transportation to zoology. In Airframe, veteran reporter John Lawton, 68, observes, “the irony of the Information Age is that it has given new respectability to uninformed opinion. These days, everybody seems to believe in Santa Claus, in something for nothing.” In The Lost World, Sarah Harding, a glamorous young biologist, tells her protégé, “Before he goes into the field, the zoologist reads everything that’s ever been written about the animal he’s going to study. Popular books, newspaper accounts, scientific papers, everything. Then he goes out and observes the animal for himself. And you know what he usually finds? That nearly everything that’s been written or said is wrong . . . exaggerated, or misunderstood, or just plain fantasy.” The fund industry can only hope that Mr. Crichton doesn’t next turn his critical gaze to mutual funds, where the idea of something for nothing is rife, and plain fantasy about future returns abounds.

My asking earlier, “To what avail?” regarding the remarkable advances in the application of technology, was not intended to demean them. I only ask that investors give far more thoughtful consideration to curbing the powerful monster we have created and to figuring out how to make it bow to our will, not us to its will. We must begin by obliterating the notion that funds should be treated as individual stocks—actively traded, sometimes in exotic forms, by managements that can create miracles. Abandoning the massive advertising of funds as though they were beer or toothpaste or perfume would be a step in the right direction. And we ought to give serious consideration to appropriate limitations on frequency of exchanges, restrictions on telephone exchanges (though that won’t help much as the Internet becomes our transaction mode of preference), and fee penalties paid by investors when they redeem shares after short holding periods. All of these steps would be met with horror, not only by short-term investors who are using funds as stocks, but by the fund managers who seek additional assets without concern for their durability. But each of these steps would help the long-term investors we are sworn to serve.

Consider the words of Benjamin Franklin at the close of the Constitutional Convention in 1787. Speaking of the new republic that had just been created, he pointed to General Washington’s chair, on which a sun was painted in gold leaf. He observed: “I have in the course of the Session, and the vicissitude of my hopes and fears, looked at that sun without being able to tell whether it was rising or setting. But now I have the happiness to know that it is a rising and not a setting sun.”

TEN YEARS LATER

The Pervasive Impact of Technology

As we now know, the sun of technology proved to be a rising sun, and the end of its rise—perhaps even its domination of the investment process for a while—is not yet in sight. But the self-inflicted damage it has done to financial institutions and to fund investors has vastly outweighed its potential benefits and economies—surely a setting sun for them. As I mentioned in Chapter 5, Morningstar data clearly (and almost uniformly) confirm that traders in indexed ETFs have earned returns that fall far below the returns earned by the respective indexes that the ETFs track. While the annual return of the typical ETF was flat during the five years through mid-2009 at 0 percent, its investors earned an annual return of -4.2 percent. That’s a cumulative loss of some 20 percent of their capital in just five years.

All of this trading, when successful, engenders extra taxes, a large additional cost for active individual investors. (For buy - and-hold investors, capital gains taxes are largely deferred.) I should have added a word about taxes in the earlier edition. The traditional costs that tended to limit trading activity have pretty much vanished, and taxes no longer create significant frictional costs for most institutional investors. Endowment funds are exempt from federal taxes, and about half of equity mutual fund assets are in tax-deferred retirement and thrift plans. (What’s more, the other half of assets are managed as if they were tax-deferred, leaving fund investors to pay the excessive tax costs.) I believe that federal tax policy should be used to discourage this casino-like trading, and suggest that we create a new barrier of, say, a five-cent tax on each share of stock traded. This tax would also help balance the federal budget, and reduce the deficits we’re now inflicting on future generations.