January 18, 2009

Reasons to Avoid Mutual Funds

Posted in finance tagged , , , , , at 5:48 pm by mj

I’m finishing up David Swensen’s Unconventional Success: A Fundamental Approach to Personal Investment. This is part of my self-study aimed at becoming a better investor. (You may notice more finance/investing articles here and on my link blog. I’m finding it incredibly interesting.)

Swensen manages Yale University’s endowment, and is generally known as one of the top fund managers in the business.

Swensen advocates systematic portfolio rebalancing, which increases returns and decreases variance year-to-year. Unfortunately, the rebalancing activities required often run against our instincts, so few have the discipline for it. Even most mutual fund managers.

A large part of his book is devoted to explaining, in excruciating detail, and with more statistics than you could possibly process in a single read, why mutual funds are a bad investment.

Consider this small excerpt, comparing the offering of mutual funds to a standard, passively managed index fund (all emphasis is mine):

Fifteen-year results show a scant 5 percent probability of picking a winner. […] In a cruel twist of fate, for those skilled (or lucky) enough to identify a mutual-fund winner, the gain proves far more mediocre than the race track’s long-shot payoff, as the average winnings amount to a scant 1.5 percent per year. Fully 95 percent of active investors lose to the passive alternative, dropping 3.8 percent per annum to the Vaguard 500 Index Fund results.

And a bit later, discussing tax implications in non-tax-deferred accounts:

A miniscule 4 percent of funds produce market-beating after-tax results with a scant 0.6 percent margin of gain. The 96 percent of funds that fail to meet or beat the Vanguard 500 Index Fund lose by a wealth-destroying margin of 4.8 percent per annum. Arnott notes that “starting with an equal amount of money in 1984, fifteen years later an investor in the average losing fund would have roughly half the wealth that would have been amassed had the money been invested in the Vaguard 500 Index Fund.”

He goes on in his book to outline all the reasons: high sales (load) fees, commissions, marketing fees, hidden fees, poor/average managers, conflicts of interest, trend following, using skewed statistics as marketing pitches, etc. And those are just the obvious, legal reasons. The mutual fund industry is steeped in misdirection and outright fraud.

It strikes me as unfortunate that the most prominent form of investing for the average person–401(k) accounts–is driven by the mutual fund industry. What’s worse, the typical 401(k) account does not even have access to all mutual funds: it’s usually a pay-for-play affair.

So even if you identified the best mutual fund managers (1 in 20 probability), you’re completely at the mercy of whatever financial deal your employer has struck, and likely you have no choice but to invest in (at best) average funds. And all of this is endorsed at multiple levels of the government, not least of which the IRS.

Anyhow, I highly recommend this book. There are only two shortcomings that stick with me.

First, as a numbers guy, I wanted more numbers, more charts, and to see the data behind summaries. But he provides an excellent bibliography section, so I can always go look it up. (Might cost a bit, though.)

Second, he could have included 20 more pages worth of explanations. Sometimes he assumes you know more than you probably do (or maybe I’m just more ignorant than the average reader), requiring a re-read and visit to wikipedia. An extra paragraph here and there (no more than 2-3 pages per chapter) would have gone a long way.

But those are minor. Go buy it.

I will also read his previous work (which has a new edition now), Pioneering Portfolio Management, which, I suspect, will be even meatier.

He’s given me a lot to think about, and a lot to study. I will also perform simulations with what I’ve learned to better understand how things play out and what the downsides are, which I’ll try to incorporate into future posts.