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Why I hate most mutual fund investing

April 25, 2016

MutualFundGreed1

 

“I have bad news and good news.  The bad news is we lost a ton of money.  The good news is that none of it was ours.” – Investment banker addressing colleagues after collapse in mortgage-back bond market

I’ll start with the basics of why I hate the financial / mutual fund industry so the next time you’re meeting with your “financial adviser” or 401k “adviser” you’ll be aware of some things they may not be sharing with you:

The industry is incentivized all wrong
Managers – particularly hedge managers – are paid to take huge risks.  If they take huge gambles and it pays off, they get a huge bonus.  But if they don’t pay off, they don’t eat the losses.  Sure, the investors may lose some or even all their money, but it isn’t the manager’s money.  All upside, no downside.

Example:  Year one, a manager places a crazy bet and wins, he gets paid a huge bonus.  Next year he does it again, and wins, again, another huge bonus.  And the next year, his luck runs out and the fund runs massive losses for investors.  But the manager gets to keep his past bonuses.  It made sense from his perspective to do exactly what he did (not from the view of the investor).

I have a retired 32-year old friend who used to manage a hedge fund and he talked about this phenomenon.  I asked what he does when the gambles blow up and they lose all the investor’s money:  “Go get other investors.”

Understand this and you’ll understand most of what drives the behavior of the financial fund managers.

With all that speculation, 95% of mutual funds eventually under perform or blow up
Most people think mutual funds are around for 20-30 years.  Over a 10 year period over HALF of the funds will disappear.  They do so poorly that the fund companies just get rid of them.  Of the remaining funds that survive, 95% of them will underperform the market average over 20 years.  

People have been suckered into thinking mutual funds can beat the market when 95% will underperform.

In fact, funds are often such bad investments that between half and eighty percent of funds managers own no shares (zip, zero, zilch)  in the funds they manage.

How does the public have any chance when half the funds can’t even make it 7-10 years and half the “professional” fund managers don’t invest their own money in the funds they manage?

Mutual fund real returns are much lower than they report themselves
I don’t know how this is legal.

Mutual funds report their returns based on what they call “time weighted” instead of dollar-weighted returns.  What’s the difference?

Imagine a fund goes down -50% and then up +50%, a fund then reports “it has an average return of 0%.”  But what actually happens to the money of their investors – which by the way is the ONLY thing that counts?

$1,000 went down -50% to $500 and then back up +50% to $750.  $750 still has to go up another +33% to reach $1000 or the 0% that the mutual funds report.  That’s a long ways from what they report they earned.

Studies show most funds reporting 10.0% rates of average return actually are earning investors less than 7.5%.

For example, over a 25 year period ending 2005, the S&P500 index returned 12.3%.  Funds reported they earned 10% – keep in mind those are the funds still around.  On a dollar-weighted average, investors actually earned 7.3%.

Not only do mutual funds under-perform what they report, they underperform the market to the tune of nearly 5% per year.

How much of a difference does 5% make?
Nearly 4x.  Over that 25 year period, mutual fund investors on average experienced a 482% increase in their capital.  Yet those who just bought and held the market through a basic S&P index fund earned 1718% – nearly 4x as large!!  That’s $250,000 vs $1,000,000.  A life changing difference.

Guess where that $750,000 of investor money goes?
Fund manager’s bonuses.  Lawyers.  Advising fees. Fund expenses.  Trading costs.  Lots of advertising to attract more money.  And just under-performance from bad bets and bad management.  All of that loss is like compounded interest – but against you.

What about all these funds I read about that out-perform the market?
Mutual fund companies are smart.  They start multiple funds at one time.  Some funds under-perform or blow up.  The fund companies get rid of them.  The funds that survived/”succeed”?  They showcase them in brochures.

Who do you think funds are targeting with glossy brochures and pictures of beaches and smiley couples?  The rich who are already retired?  They’re targeting the naive, return-chasing middle class.  

The cruel reality is, those funds who gambled and now have higher returns for a short term (3-5 years) will subsequently have their long-term average (10+ years) returns revert to the mean (10%).  In order for that average to drop, the following years’ performances will be much, much worse.  Ironically right as the middle class is jumping in.

So the investor gets hammered.  But for a while, the manager has more money to work with and subtract fees from (before you hop your money into another hot fund they have).

Screwing summary:
Managers are incentivized to gamble money for huge returns because they have huge upside if they win and almost no downside if they lose.  Most fund managers don’t invest in their own funds.  Over half of funds can’t survive 7-10 years.  The returns funds report are on average 2.7% lower than the returns you’ll earn.  Those that happen to perform well likely subsequently perform horribly.  On average, over a 25 year period, mutual funds reduce 75% of stock market growth.

If I’m going to invest in the stock market, where should I invest without getting screwed?
A well constructed study showed over a 20 year period a Vanguard S&P 500 index fund would help you beat 95% of everyone who is getting suckered by mutual funds.

The math is so compelling that Warren Buffet made a famous million dollar bet with any fund manager that Buffet could put his money in a Vanguard S&P 500 index fund and do nothing but hold it and he would out-perform any fund “professionals” willing to take the bet over a 10 year period.

Protege Partners took him up on it.  Eight years later, Protege’s picks are up 22% and Buffet is up 66%.

When Buffet dies, his will directs that the majority of the money his wife will inherit is to be invested in a Vanguard S&P 500 index fund.

Pause.  Really think about that.  The richest person on the planet gives the person he cares for most the following financial advice:  Vanguard S&P 500.

If he has access to nearly unlimited funds and the best money managers in the world, why would he recommend this unless mathematically it was the best play.

Why are Vanguard Index funds so much better?
Not all index funds are created equally.  Vanguard funds have 83% lower expenses than similar funds.  Who gets that savings?  Investors.  They don’t gamble to beat the market, they just match it.  They’re structured as a non-profit – so extra savings is returned to investors.

Do your own research.  Google it.  Depending on the time frames used, quality of the research, and other factors, the numbers can be a bit higher or lower.  I’ve endeavoured to use averages reflecting somewhere nearer the middle.

The most important thing is you do your own research.  It’s your retirement that you’ll work 30+ years to build.  The advantage of being an informed investor:  A retirement 4x as large.  $750,000 more is a life-changing difference.

Update 5/3/16:  Warren Buffet goes on rant against Wall Street, hedge funds, and investment consultants.

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