Send me real-time posts from this site at my email

I Know Why Mutual Funds Fail to Perform

"Why, sometimes I've believed as many as six impossible things before breakfast."
--The White Queen

You've heard this a hundred times, I'm sure: Most actively managed mutual funds fail to beat the S&P 500. [i]

Certainly the battle between active and passive management of financial assets seems to be one not going well for the stock pickers, as passive funds attracted more than $500 billion in 2016, while active ones saw more than $340 billion in outflows.

The general assertion is that fund managers lack the skill necessary to outperform the benchmark -- some formulation of "YOU SUCK AT YOUR JOB." Which is a reasonable assumption, except that it makes very little sense that mutual fund companies would en masse turn their portfolios over to people who show so little aptitude.

Most people commenting on mutual fund performance haven't actually ever run a fund. But I, after having launched and managed three funds with Motley Fool Funds, have the unique opportunity to look through both lenses. No, good Fool, the problem isn't the portfolio managers -- not all of them, anyway. The things that actually cause mutual fund underperformance are far more pernicious than mere incompetence.

In brief, there are four main factors -- customers, consultants, regulators, and structure -- that force mutual fund managers into conventional thinking, when the key to extraordinary market returns is unconventionality. It's a basic disconnect, and it is really hard to resist.

New York City's Financial District. Image source: Getty Images.

The basic problem, distilled

At the core of mutual fund management is an agency conflict. Fund shareholders benefit, obviously, when the value of their shares goes up. Fund managers, on the other hand, make more money by growing assets under management, providing a powerful incentive for them to gather assets even if doing so comes at the expense of performance.

You might think that shareholders would welcome fund managers tying compensation to performance, but my own experience is the opposite. Motley Fool Funds originally included a fulcrum, paying us more if our Funds outperformed and less if they trailed. Fund investors, especially institutional ones, hated it because they simply wanted to know how much they were going to pay, and the surefire way to accomplish this is to charge a flat percentage of assets under management. 

This will not be the last time you see a preference for predictability over performance. In fact, customer preference is a huge part of the problem facing funds.

Blame the customer

It's The Motley Fool's purpose to help investors make better decisions. Honestly, I think if we did that and never made a good stock pick, we'd still be helping folks, because while the average mutual fund underperforms its benchmark by a little, the average investor in those funds underperforms those underperformers -- by a lot.

Source: Davis Advisors.

This is a Davis Advisors study distilling the gap between the average stock fund return (9.9%) versus the returns of the individuals who invest in those very funds (3.8%). This "investor behavior penalty" over the long term is absolutely devastating.

"Wait," you say, "I thought you were about to blame customers for mutual fund underperformance." Yep.

Most mutual fund managers know full well that individual investors buy and sell at the wrong time because they see it every single day, and that behavior impacts how fund managers behave.

Mutual funds are pooled investment vehicles. The fund manager controls the stocks that go into a portfolio, but he or she has no control over the timing by which fund holders add or subtract money. Which brings us back to the chart above -- they're really bad at both.

To avoid being whipsawed by an unanticipated redemption (the only kind), fund managers tend to keep a cash cushion. At Fool Funds, we knew we'd see larger redemptions if the markets dropped for two consecutive days, and in a pooled investment vehicle, redemptions are met are by selling positions held by all remaining shareholders.

Blame the institutional investors and their infernal consultants

The first time a fund consultant asked me about the Motley Fool Funds' Sortino Ratios, I answered that this kind of statistical inference wasn't something we cared about. Turns out this was the wrong answer, if making a fund consultant happy is your game.

Fund consultants are the gatekeepers to the big investment dollars. Individuals invest in chunks of thousands. Institutions invest in more comma-rich denominations and control the overwhelming majority of money invested in mutual funds.

As a fund manager, you can choose to ignore institutional investors, but that's essentially telling 85% of the market that you don't want its money. That's a decision that could cost you millions in potential revenues (or, perhaps in our case, did cost us).

The institutional game makes good investing in mutual fund constructs hard, because good investing requires some sort of unconventional thinking, and institutions and their consultants essentially force fund managers to be as conventional as possible, favoring the short term over long-term investing. Fund managers are under pressure to be predictable by showing low tracking error (i.e., having returns and volatility characteristics that are similar to their benchmarks), which essentially means funds have to try to beat their benchmarks while tracking their benchmarks closely. Does that remotely make sense?

It does to institutions and their consultants. The logical response for fund managers is to stay as close to the benchmark as possible -- what is known as "closet indexing." It is, unfortunately an unintended consequence for an industry that forces its investors to be measured against something. In this regard, they are helped by their regulators.

Blame the regulators

At Fool Funds, we wanted the Independence Fund to be a "go anywhere" fund, measured against nothing except maybe a cost-of-capital hurdle rate. "Sorry," said the Securities and Exchange Commission, "that cannot be done. Pick a benchmark." So we did. Which, by the way, is one of a myriad of things that costs mutual funds lots of money. 

All in all, mutual fund regulation is really good. It is, for example, almost impossible for a fund manager to commit fraud against its shareholders, which is a testament to the SEC and the rules put in place under the Investment Company Act of 1940, the primary piece of legislation overseeing mutual funds. If you own a mutual fund in the US, have comfort: Your money is safe in this regard.

But in other ways, regulators make funds hard to manage and needlessly expensive, with lots of box-checking against risk factors that aren't truly risky and safety measures that don't keep you safe. For example, Fool Funds sought to launch a stripped-down mutual fund for people with portfolios of less than $15,000. This fund's expense ratio was to be 0%, with The Motley Fool bearing the cost. We had devised all sorts of ways that The Fool would benefit from having such a fund, and we had devised a way that it would be very cheap to manage. But we were hell-bent on providing a service to a constituency that the financial industry totally ignores.

And we figured out very quickly that regulations would prevent us from doing it, primarily because the "all sorts of ways" fell afoul of certain rules requiring that all investors in a fund pay the same thing. (This "everyone must pay the same thing" rule is going to come up again in a second.)

Think of that. We wanted to launch a mutual fund that charged less wealthy Americans nothing to manage their money, and we couldn't.

Blame the structure

Hoo boy, here we go. This is the thing that the financial media absolutely does not get about mutual fund expenses. My friend Jason Zweig, one of the best financial journalists alive, has repeatedly and for decades called actively managed mutual funds absurdly expensive and has wondered aloud why fund fees remain so stubbornly far above what he thinks investors ought to be paying.

Here's why: The cost of offering a mutual fund is way higher than people think. If a fund company wants its funds to be carried on the big platforms (i.e., the brokers where most people keep their portfolios) like TD Ameritrade, Schwab, Merrill Lynch, Fidelity, etc., they must execute a contract paying the platforms for the right at a cost of about 45 basis points (0.45%) of assets held. You see, funds aren't like stocks. If a fund advisor [ii] wants people to be able to buy shares through a broker, in almost all cases, the fund manager is paying for the privilege.

This is one of the least negotiable costs in commerce, and even if it's not a cost charged directly to fund shareholders, if a mutual fund advisor has to pay something, you can bet the cost is ultimately borne by the shareholders.

Most fund companies (including Fool Funds) also offered investors the option to invest directly with them, but the majority of investors come through one of the platform, so most mutual fund companies have no choice but to pay to play.

Remember that "everyone must pay the same" regulatory rule? This means that fund companies can't offer a discount for money invested directly instead of through the platforms. This 0.45% cost is functionally invisible to shareholders (I've never seen a journalist mention it), but it single-handedly keeps expense ratios high.

And there's more where that comes from. Funds must, by law, have a benchmark. Think that benchmark data is free? Hell no. In fact, there are all sorts of expenses that must be paid either by the fund's shareholders or the fund's advisor (i.e., the company that manages the fund), including custody, transfer agency, quotes, insurance against things that are more risk than hazard, and regulatory and filing fees. And anything that the advisor pays is certainly built into the expense ratio it charges, unless the advisor happens to be terrible at business.

Fund expenses cannot get much lower than they are at present unless that platform cost breaks lower. Some of the big guys have scale to ignore the platforms (Vanguard) or to negotiate lower fees. Most don't. I've been waiting in vain for years for a financial journalist to open the hood and examine where mutual fund expense ratios go. Never seen it happen.

So, how do you find a good fund?

We come now to the obvious question: Why would anyone invest in actively managed funds at all? Warren Buffett suggested recently that most investors would be better off in index funds. Given the forces aligned against good mutual fund performance, I'd say he's mostly right.

But if you are willing to use actively managed mutual funds in the right way, and you are truly a long-term investor, the answer is a little different.

According to a recent Morningstar study, out of a universe of 305 large-cap funds with 20 years of operating history, 107 beat their benchmark over that length of time, by as much a 4.6% per year (which, thanks to the power of compounding, really adds up!). Interestingly, of these 107 funds, the majority underperformed during 10 of the 16 rolling five-year periods over that 20 years. So time horizon matters, and it has to be huge.

If you want to find a good actively managed mutual fund -- and they do exist -- seek out, first and foremost, noncomformity. Look for funds that resist easy categorization, ones that have portfolios that don't change that much but are vastly different from their benchmarks. Even look for ones that are not available through the big brokerages.

Lest you believe this claim is facile, consider this: Managers who run oddball funds that don't fit easily within one category, have wide tracking errors, and have high active share (the difference between their holdings and that of their benchmarks) have essentially turned their backs on huge amounts of potential assets. They're either completely stupid -- which is possible -- or they are investor-centered.

[i]

This is something that as a fund manager absolutely drove me crazy, though. There's a reason most mutual funds are benchmarked against something other than the S&P 500, and that's because they are supposed to do a job within a portfolio that is different than mimicking the S&P 500. Comparing an emerging-markets portfolio -- made up of companies from developing countries all over the world -- against the S&P 500 is like trying to diagnose what's wrong with the transmission of a car by checking for flat tires. Totally inappropriate. An emerging-markets fund should be compared to an appropriate benchmark like, for example, the MSCI Emerging Markets Index.

[ii]

A little mutual fund nomenclature might be helpful. A mutual fund (or a series of funds) are organized into a corporate structure called a "trust." The mutual fund company, be it Vanguard or Fool Funds or Fairholme or any of hundreds of others, advises the trust on how it should invest shareholder money and is therefore known as the "advisor." And the "fund manager" is the person, or set of people, or computer, or super-intelligent strain of rhubarb, or whoever is actually tasked by the advisor to manage the fund.

The $16,122 Social Security bonus most retirees completely overlook
If you're like most Americans, you're a few years (or more) behind on your retirement savings. But a handful of little-known "Social Security secrets" could help ensure a boost in your retirement income. For example: one easy trick could pay you as much as $16,122 more... each year! Once you learn how to maximize your Social Security benefits, we think you could retire confidently with the peace of mind we're all after. Simply click here to discover how to learn more about these strategies.

The Motley Fool has a disclosure policy.

Cancel

Popular posts