Mutual Funds for the Utterly Confused

This is a continuing look at the “rejected introduction” that I thought was too good to waste but was not setting the right tone for the book.

Funds do need to publicize their returns if they have returns worth publicizing. Not many do. When a fund places high on this list or that in relation to its peers, it becomes part of the ad. Even the least savvy among us will look just a little further than the advertisement.

And when we do, we will focus on the return on our investment.

In the ad copy, the ROI is usually touted as a percentage from usually one, five, or ten years removed. It is the most widely considered piece of information about a fund when a new investor seeks to make a decision about investing in this fund or that or, in some cases, whether this fund or that is still worth investing in anymore. So that number can have significant and numerous meanings depending on how you read it. And what you read into it, “how much would my $1,000 be worth had I invested ten years ago” has little bearing on where the fund is now or where it will go in the future.

Sadly, no matter what they try, mutual funds will always have detractors, quick with the scalpel to dissect intent from perception, truth from fiction. And even though I like mutual funds, I will do my fair share of cutting as well.

We will talk about those comparative indexes that funds all slide up alongside of hoping to look the best that they can. The Internet offers unparalleled opportunities to compare the raw numbers offered by funds if you know what you are not only looking for but once you find it, what you are looking at. This book will help you understand what those numbers mean, what they are attempting to portray and whether they will find its way into our style box.

That’s right, we needed something to keep track of what we think is important in a fund. I am going to pick six attributes of mutual funds that I like and we will try to find those characteristics in other funds. Some will have a few; others will have all six. The funds that put the most inside our style box will excel at returns over five years, taxes over the same period, turnover, style drift, and management style.

All funds come with a claim about where they have been. Past performance, they will say and only because regulations warrant them to, are tied to numbers that might not be do-able year over year, or even quarter over quarter. That well-worn disclaimer is often heard so frequently that we gloss over the intention or even what it means.

Funds have great difficulty staying on top of the heap. In fact, the failure rate, based on the fund’s ability to match or best the index of comparable value, some suggest could be as high as 75%. So why run the risk of investing with mutual funds if they have such a high degree of disappointment?

The simple answer: On your own, as an individual stock investor, you probably could not do much better and will, in all likelihood, do far worse.

None of us want to believe that behind the façade of mutual funds lies a network of protectionism supported by huge lobbying effort with a seductive, empathetic, and often guilt provoking media blitz. None of us want to believe that these investments are more than just a group of like investors focused on a similar goal, entrusting our hard earned dollars to that end with a person(s) and even sometimes a computer. So we mostly ignore the facts we need to make better decisions.

We would instead like to believe that Dave Barry, humorist and author might have a answer closer to the truth about mutual funds. When he suggested in a February 19, 2006 blog posted at the Miami Herald that investors “FORGET MUTUAL FUNDS: You want to be in tiger poo” he may have hit upon something. Not that large cat feces might be a better investment but the fact that we are a gullible sort that might just believe anything we hear, we need to be careful.

In an article promoting his book, Mr. Barry told New York Times business reporter Paul B. Brown that investing in the stock market is simply a series of pat moves: First the long term analysis over a twenty-five year period. Then, pick the best 10 of a thousand or so stocks and buy them – right after you book the first time machine headed back twenty-five years. Cool.

But until the technology catches up with the strategy, we are left to develop some pat moves of our own when buying mutual funds and some of them even involve analysis.

Are any of you familiar with the theory of control? Unless you subscribe to science journals, it is no more likely to pop into our every day conversation than the name of a mutual fund manager. Control theory has its place in this conversation though.

When was the last time you wondered if such and such “could walk and chew gum at the same time.” Granted, it is a somewhat cruel reference to someone’s inability to do two things at once but simple everyday control is often something we do not think about. We rarely refer to our mastery of some of the most mundane daily activities as an act of control. But we are in control, without thinking about it.

Control theory attempts to describe the event. Imagine the simple act of walking. It employs muscles and blood and oxygen and balance and should something cross your path suddenly, it adjusts all of those things instantly adding an element of coordination just in time. All of that takes a split second but it is done in such a fashion that it applies all of those changes in a controlled, seamless way.

John Doyle is a professor of control and dynamic systems, electrical engineering and bioengineering at Caltech. His primary concern of late is how to create a theory to accelerate the flow of information through the Internet, without of course, bogging it down. This is not his first project of note. He was once invited by NASA to look at the space shuttle wondering if he could predict certain behaviors during reentry. In that instance, NASA was worried that, even though the first several shuttles encountered no difficulties, there may be something they were overlooking, something that would be disastrous.

Numerous math calculations later, he pronounced the shuttle well within the range of calculable safety – provided something major did not disrupt the re-entry process. Being able to calculate the dangers out of the equation made NASA feel much better about that all-important critical time for any space flight. It doesn’t matter what the situation is, the complexity of what might happen, or what is happening at all, control theory helps identify how the process works.

As I mentioned in the previous post, this is the original introduction to the book - that was rejected, not so much for content ans for tone. We we get to the intrduction that actually appears in the book, you will see what I mean.

From where we left off:

Then, there is the cost of doing business. Mutual funds might also wish they could keep the fees and charges they collect from investors for their professional services as close to the vest as possible but once again, it is generally public knowledge how much it will cost.

And then, to further complicate matters, mutual funds are beholden to more than you and me and the thousands of other investors in the fund. The fund family is often part of a publicly traded company! Stock exchange listed equity can own a mutual fund that in turn invests in stocks! That, in my opinion adds the final touches to this tarnished investment.

Once again, I love mutual funds. Despite all of the seedy underbelly-like dealings and clandestine deceptions, mutual funds, which play a roll in 95 million investor’s lives, have a certain quixotic appeal. Even as we need them, we are, at the same time welcome to loathe them.

We will, if we are like most people, use them in our retirement planning, perhaps to park cash for short-term safe keeping, or even to help finance our children’s higher education. Some of us even invest in them – as an investment! And most of us do not have a clue about what they are, how they operate, or how to use them to our best advantage.

They can be, once they are dragged into the light of day, a very good investment for everyone and an important part of every portfolio.

But first, let’s consider Mr. Farrell’s scathing description of the industry we are about to talk about at length. Mr. Farrell observes mutual funds with a certain disdain suggesting that the person(s) at helm of these investments is only there for the money.

I can go along with that. If you think about it, we all are in one thing or another for the money. It’s called work. But do fund managers hauling down around $400,000 a year on average merit more scrutiny than the $40,000 a year butcher cutting your meat? Oddly, I think we wonder about the guy tying your roast more than we consider the people investing our money.

Still, you might say that anyone earning about ten times the average annual paycheck of the average American should be worth looking into if only for that reason. We distrust all high paid brushes with professionals (doctors, lawyers, politicians), limiting our trust to place somewhere between acquiescence and blind.

Fortunately, we have better measures than the simple use of paychecks. Money, as they sometimes say has legs and investors seldom hang around with a manager that isn’t earning his/her/their/its compensation.

The pay does seem a bit out of whack for what we perceive the job to be, but it is not the only reason Mr. Farrell thinks that we could not only do better without mutual funds. He believes we should all consider opening a fund of our own. Sort of a “I am a Mutual Fund Manager (and so can you)”.

If only beginning a mutual fund was as easy as Mr. Farrell suggests. His description of a fund as an organization is headed by a person who needs to be finely dressed, able and ready to market both herself or himself to the public as not only a talented investor with enviable skills and insight but some one gifted enough to possess the ability to discern the markets direction.

They will need to be polished enough to appear on television, speaking about this piece of news or that, and hope that high-definition will be kind to them. To Mr. Farrell it is a mutual fund as a runway reality show.

To prove those skills he/she/them/it then needs to be able to beat whatever index they choose to target and at the same time, gather unto their folds, similar investors with the same ilk.

Naiveté is a generally preferred trait among mutual fund investors but is not necessary. Even fund managers know that the most experienced investor is prone to flights of fancy, investing where he or she ought not, ignoring what they know for what they feel.

(Benjamin Graham suggested that these two investors are in each of us. The naïve can also be the experienced and vice versa. And by his own advice, he suggested that these investors who were tempted to commit money to folly should keep a separate account for “mad money.)

Mutual funds also need to have a very good idea of who you, the potential or current investor, are. They count on a certain level of inexperience when to comes to the investing public. They know that if they advertise with great skill, they can brand themselves without the need to include too much technical information to muck up the pitch.

A Retired couple lounging on their beachfront porch or a kid packing the last remnants of her bedroom in the back of your car as she heads off to college are all images the untapped investor class needs to tug on the their emotional heartstrings, which mutual funds hope, lead to a quick pull of the purse strings. If half the people in the United States are not invested and the 95 million who are invested in mutual funds do so because it is all that is available, it pays from them to advertise. Portraying a hypothetical you with your grandkids or as someone who just doesn’t have time to do the investment work yourself while you are several beers into a football game or turning the page of your favorite periodical, mutual funds hope to get you to remember who they are and more importantly, what they can do for your future.

Mutual funds know stuff about us that we might not be so proud of as well. Higher expenses Farrell writes and I paraphrase, often lure some investors in because they perceive the additional cost as indicative of better performance. As much as we pride ourselves in looking for ways to be frugal with groceries or clothes, mutual funds know that we do see ourselves as smart when the perception of spending more than you need to seems to provide the outward appearance of savvy. On that point, they are laughing all the way to the bank.

Then, Mr. Farrell suggests that to succeed at their game, you, the manager, with all of that information about what makes us the most vulnerable to your fund’s purpose, all you will need to do is find the right name. Perhaps something patriotic sounding to stir the inner investor to do the right thing for not only them but also the country and you will have a mutual fund of investor-worthy merit.

In their defense, mutual funds are run on mutual participation. They need to attract new investors and convince old ones to recommend the products they use to friends and family. And to do that, they are often forced to promote the people who run them, often like Wall Street rock stars.

The fund’s publicity department often sees managers, who have excelled at the helm of their fund, as being ad-worthy. Its like hearing about a local restaurant featured on a national food network show. You may have never been there but if you had, you would have felt good about your choice of cuisine and because it was recognized, you by default felt better. Their success makes you fell smarter. Same goes for mutual funds. Nothing would be better than having a fund manager’s name pop during a conversation, maybe, perhaps while they are fencing.

As the first gentleman offers the feint, then they parry as the aggressor offers the suggestion that his current financial success is because of - then a disengage, followed by a counterattack - a certain fund manager. Try it sometime when you are getting the best of your opponent in a game of one on one basketball. Start talking finance during your jump shot or perhaps as you administer a wicked backhand during tennis. Hey, doesn’t everyone talk about the state of his or her investments during the heat of the moment? Everyone does it, right?

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The next post will continue with publicity.

My editor had me redo this introduction after he asked for an early read. He felt as though it was too heavy-handed. And truth be told, it was.

Nonetheless, it wasn’t bad for having been kicked to the wayside. Over the next week, I will be giving you a look at this unused material before we move on to the actual chapter by chapter look at the book and some of its many analogies.

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Introduction: What went Wrong with Something so Right?

Regrettably, I have to agree that Peter B. Farrell of MarketWatch.com was right on the money when he skewered mutual funds in a column he published online recently. Once the investment that occupied the quiet corner, these all-but-ignored funds have developed some bad habits while we weren’t looking. And despite all of the regulation that governs these investments, they have found a way to create a bad reputation.

For some, it was well deserved. For others caught in the sweep of negative glances from the public and scrutiny of regulators, the fallout was overdue. And yet, they are doing little to change the current public perception of mutual funds as anything other than a necessary evil tucked inside a retirement plan.

Mutual funds are, for want of a better description, a somewhat nefarious and deceptive investment that are run by managers – men, women, teams and/or computers that often seem, at least of late, to be using them only as incubators, auditions in some respects for the real money to be earned sometime down the road when they create a hedge fund of their own. This “land of opportunity” bravado that our mutual fund manager may embrace, works and is largely tolerated when he/she/them/it is focused on the reason we hired them in the first place. But when he/she/them/it puts their interest in the fund too far to the forefront, then you can pretty much rest assured that his/hers/their/its bravado may not serve our interests.

It would be nice to say the mutual fund industry wasn’t always so ‘cloak and dagger’, but to some extent, it always has been. Funds, the people or machines (which have people behind them), or the companies behind the fund companies (often publicly held entities who are beholden to yet another group of shareholders) try to hold their most intimate details close.

Maybe its just me but they seemed to get even more secretive in light of the sheer number of new private investment groups like hedge funds that have exploded on the scene of late. Worried that the competition might get a “leg-up” on some sort of investment style, they dodged transparency in favor of opaque strategies.

Fund managers and the funds they run have always been a somewhat shadowy enterprise but now they seem to be more so. This does not bode well for investors who, study after study have proved to be easily swayed by a certain name, a perceived image of the strategy they employ, or the overall empathetic approach or goal their advertising employs and practically promises to deliver.

Sure, there are secrets to guard. The kind of stocks held in a fund’s portfolio, in a world changed by the Internet, is as close as your computer. There are a finite number of stocks and equity offerings a fund can invest in and, with a good computer processor, there are only a finite number of ways they can invest in those stocks. Your access to what they hold is usually limited to the top ten stocks in the portfolio. Once on the inside however, and you have the entire portfolio – or at least a list of holdings from the last quarter – in the prospectus.

Mutual funds have created the questions investors are supposed to ask. “Which index do you compare fund YYYYX to?” an investor has been conditioned to ask. Until the creation of the first index fund in 1975 by legendary investor John Bogle of the Vanguard Group, where funds harder to buy? Did indexes really change the industry to such a degree that we could not determine who did better than whom at any given moment? But is asking about who to best use as a comparison even the right question? How hard is it for an actively managed mutual fund to pick an index? By actively, which I will discuss throughout the book, I refer to a fund whereby the managers, be them man, woman or machine, trade their underlying holdings based on some charter the fund is supposed to follow and to do so in pursuit of making money.

Can it be done? Should it be done? They are, in a sense, comparing apples to oranges, actively managed stock portfolios to relatively fixed ones and then they expect us to take those considerations into account and pick a winner. Should a fund manager pick the right index to use for comparison however and magically you can be considered good or perhaps even among the best.

Is an actively managed fund only as good as the index it uses for comparison? Or is there something more? Imagine how many potential investor you might attract and what current investors might do should you improve your rank among your peers. Imagine the bragging rights you would have and all the fund needs to do is beat that benchmark.

To be counted among the best, you need to do it consistently and succeed in besting that mark over a period of time that should encompass years. But we will discuss all of that later on. We will also include a discussion on those indexes as well, a not-so stagnant pool of holdings that has recently shifted shapes, a feat that further confuses the investment waters we are attempting to navigate.

Don’t misunderstand me. I love mutual funds. Always have. Which is why I tend to be critical of them. That criticism will show through at times but it is only because I don’t see the reasons behind some of the things the industry does.

The next post begins with the following phrase: “Then, there is the cost of doing business.”

While I work though the chapters the copyeditor has sent me, I thought you might like to take a look at the front cover of the book.

 

Eventually you will be able to purchase signed copies from my main site BlueCollarDollar.com and you can place pre-orders via the comment section below.

If you have ever received a letter from your copyeditor, you will understand the fear it can strike in your heart. Well, at least the first time.

Pattie was the first copyeditor I worked with and I continue to ask for her when I do a book for McGraw-Hill. I’m not sure what to look for in a copyeditor but she seems nice in the phone conversations I have had with her. I don’t often speak with people on the east cost, where I grew up and the sound of her voice makes me homesick. But, I’m not three thousand miles away by accident.

She opens the letter:

“Dear Paul,

“Attached to this e-mail is the first batch (Chapters 1-8) of your electronically copyedited manuscript, ready for your review.”

This does sound so bad. And if the experience is like all of my previous ones, there are generally not a lot of changes. Pattie does say that she has her best talent on the job and warns me (nicely) that this particular woman uses a fine-toothed comb to seek perfection with every turn of the page.

She does say that I can disagree if I want and the letter instructs on what to do and what not to do. By book four, I’m feeling like an old pro. The anxiousness is still there though and I plan on waiting a day to open chapter one. Once I begin, I can’t stop.

It is not only the revisiting of the subject I had spent the previous three months with, reviewing the “colorful analogies” (my editor’s phrase for the back cover and part of what this blog will cover), and reading what another set of (highly-trained and keenly focused) eyes might see in the manuscript that neither my editor nor I saw. But as the blog progresses, we will explore those “analogies” as they occur so you can treat this blog as sort of an online bibliography.

The letter continues:

“Please bear in mind that any and all changes to the manuscript should be made at this time, because content changes in page proofs are costly and time consuming, and will not be allowed.”

They once said that the cost of this type of thing came out of my pocket! I’m not sure why someone would decide to change anything at that stage of the process considering the mistress-like relationship you have had with the book over the past six, nine, twelve months should have left you enough time to tweak the words to everyone’s satisfaction and not make any last minute changes.

“The copyeditor will not see the manuscript again, so when you return it to me your changes must be final.

“Our usual amount of time allowed for authors to review each batch of their copyedited manuscripts is one week.”

It’s August. It’s hot. It is porch-sitting weather with a sweaty glass full of gin and tonic. See why, once I get started I can’t stop. Perhaps there are not that many changes.

“Please let me know if you won’t be able to meet this date (although in the past you’ve always spoiled me with your fast turnaround!).” I re-read the whole letter again after reading this wondering does Pattie add these little asides at the end or does she write each of these letters individually. I’m not the type to ask but its true, I’ll get them back to her by Monday night, all eight, four days early.

She continues: “Also, please remember that you don’t have to wait until you’ve reviewed a whole batch before you return it to me. You can send me chapters individually as you finish with them. This will help me get a head start on finalizing them for the compositor.

“The copyeditor is due to send me the end of the manuscript next Wednesday, so you should have them by the end of next week.” With the promise that more will arrive almost before I send her the first batch.

So I’ll strap myself in and begin Saturday morning and officially begin the blog posting starting on Monday. This should be fun for those that buy the book and want to learn more and if you happen to stop by, with luck, you will want to buy the book and learn even more cool stuff about mutual funds.