Four Things to Avoid When Choosing Mutual Funds
As the battle for financial reform continues into 2011, the battle lines are clearly drawn: It’s the professional financial services industry against its own customers.
While there are pockets of resistance, such as the Americans for Financial Reform, and the Committee for the Fiduciary Standard, have opposed any attempts at fee reform, increased transparency and adopting a fiduciary standard. Any of these reforms would address the issues related to conflicts of interests between investment product sales professionals and their own customers.
While the conflict of interest problem was addressed in 1973 by the Employee Retirement Income Security Act (ERISA), which covered pension plans and subsequently, 401(k) plan administrators and service providers, it was never applied with the same high standards to the larger retail brokerage sales side of the business.
If it were, the entire B/D business model and accompanying sales practices would have to be re-vamped. Lucrative practices which help sell funds, such as revenue sharing, would become obsolete.
While financial reform issues get complicated, individual investors should not get too depressed. That’s because you have all the power over your own financial decisions. You can hire and fire mutual fund and money managers. Outside of your 401(k) plan, there are about 7,600 mutual funds and over 800 ETFs to choose from. If anything, there are too many choices.
To help cut through the financial product clutter, here are three basic criteria to make your selections easier.
1. Avoid investing in funds using sub-advised managers, unless they have a compelling feature.
2. Avoid multi-manager funds
3. Avoid insurance company-sponsored mutual funds, unless they have a proven track record and low expenses.
4. Avoid funds which have changed managers.
Here is more on each of these potential problems:
1. Avoid investing in funds that use sub-advised managers, unless they have a compelling feature.
Many fund companies offer a wide variety of mutual funds to look competitive. But to get more fund variety, fund companies can make arrangements with other firms to offer their funds under another fund company’s name. This is the equivalent of private labeling in the retail business, and while the quality may be present in both products, the costs may be different. In the mutual fund business, it’s best to buy directly from the fund company which employs the fund managers.
Many fund companies which also provide 401(k) plan services often offer mutual funds as part of their total plan administration package. The problem is that these companies are in the plan administration business first, not the money management business. In one case, a large West Coast insurance company has an entire family of funds which are 100% sub-advised.
It then becomes incumbent on the fund company to show if its sub-advised funds have lower total expenses than if the 401(k) plan administrator could buy directly from the investment management firm. This can pose a problem to 401(k) plan participants who often have no choice in determining the latitude of their fund selections. If your 401(k) plan only offers sub-advised funds, ask for more choices.
2. Avoid multi-manager funds
A multi-manager fund is one advised by a select group of managers. The idea is that a few great investment minds are better than one. The fund allows managers to pursue different investment styles in a single category, such as a large cap growth fund.
Problems arise due to fees, overlap among the managers, and the inevitable fact that the “best” managers often do not remain at the top of their game for long.
Multi-manager funds were designed for large pension funds in the late-1970s as a way to comply with ERISA’s distinct portfolio diversification mandates.
Funds were faced with choosing the most appropriate managers to meet their investment objectives, so rather than justifying the choice of a single manager, an alert consulting-money management firm originated the idea of selecting the “best” in a certain investment category. This allowed the pension fund to meet its ERISA obligations, and put the burden of responsibility on the consulting firm to vouch for the voracity of its “best” managers.
While this was a novel idea, some in the investment community considered it an evasion of responsibility and a clever gimmick. So while the multi-manager approach met a need for institutions, it does not present the same benefits to individual investors due to higher costs (it is impossible to pay five managers the same as one) and performance.
It is better for individuals to diversify by choosing separate funds run by individual managers. This allows a higher level of specialization and diversification among the portfolio.
3. Avoid insurance company mutual funds, unless they have a proven track record and noticeably low expenses.
This may be more controversial, but insurance companies have huge overheads (primarily in sales, marketing, and administration) to support before they can ever consider reducing total fund expenses. While future fund performance is unknown, expenses are the most important known factor an investor can control before they ever buy a mutual fund. And going into the lower-return investment environment in 2011, it is critically important to manage expenses.
The U.S. Department of Labor has identified 17 distinct fees charged to shareholders by investment companies. While some costs are well-known (administrative fees for example), there are also hidden costs, such as trading expenses, which can easily double expenses, or add up to 50% to shareholders’ costs.
Since most investors do not even know these expenses exist, they invisibly erode shareholder returns. Princeton University finance professor Burton Malkiel estimates that fees of just 3% can devour up to 50% of investment returns.
Similarly, most shareholders do not know that insurance companies sell mutual funds through expensive national sales networks, which are supported by internal sales and marketing staffs, key account managers and layers of sales managers and executives. Most of these sales expenses are supported by shareholders in the form of 12b-1 and other fees.
These large networks also engage in revenue sharing deals between the fund company and investment professionals who buy the funds. This is one main cause of conflicts of interest and the resulting clamor for investment sales professionals to adopt a fiduciary duty. Unfortunately most investors are unaware of these behind-the-scenes practices, but it explains why no insurance company is in the discount mutual fund business.
4. Avoid funds which have changed managers
Changing fund managers is one of the most traumatic events which can offer to a fund company. While some fund companies use a team approach to fund management, others have used single managers, some of whom have built up impressive, long-term track records. When a manager leaves due to retirement or poor performance, it raises questions about whether the talent is leaving with the fund manager or whether there is a process in place to replicate the successful fund performance in the future.
Unfortunately, most investors do not know that answer. Unless the fund company goes to extraordinary lengths to provide an explanation for their manager succession plans, move your money.
In many cases, fund companies have contracts with their outside managers which contain specific language they must use when replacing an outside manager. For instance, they cannot say a manager was “fired;” often a fund company will only issue an announcement saying a new manager was hired. The last sentence will say who they replaced. Nothing more.
Fund companies also have been criticized for not replacing a faltering fund manager quickly enough. These delays not only hinder fund performance, but bureaucratic inertia keeps the under-performing manager on the payroll.
Another related problem occurs when managers are fired and then replaced by new managers who fail to deliver excess returns above the benchmark.
In one study of 3,700 plan sponsors from 1993 to 2002, conducted by Amit Goyal of Emory University and Sunil Wahal of Arizona State University, managers who were fired went on to deliver “excess returns [that] would be larger than those actually delivered by newly hired managers.”
The study (“The Selection and Termination of Investment Managers
By Plan Sponsors”) concluded: “We find that if plan sponsors had stayed with fired investment managers, their excess returns would be larger than those actually delivered by newly hired managers.” While this raises new questions about manager turnover, some investment professionals say it also buttresses the case for passive management.
Use Your Your Existing Power
Individual investors today have the power to control their investments, but they rarely use it. They can readily switch from under-performing, expensive mutual funds to find new managers who believe in full disclosure, avoid conflicts of interest and recommend funds which have low expenses and above-benchmark track records. There is no need to wait for new legislation, new regulations or a bull market.
While the current battle for financial reform should concern all investors, the debate in Washington will continue well into 2011. Even then, it may not produce the significant reforms which will benefit individual investors. But that should be expected.
Alternately, you can take action today to make decisions which are in your own best interests. You have that power. All you have to do is use it.
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