Mutual Funds: What's Wrong

To keep pulling in investors, managers must lower costs and deliver the goods

Investors are losing their appetite for mutual funds. Despite a fifth knock-out year in a row for the stock market and an apparent snapback in fund performance, people are putting far fewer dollars into mutual funds than they did a few years ago. Sure the numbers are huge--equity funds took in an estimated $170 billion last year. But that's 30% below that of two years ago (chart, page 69).

Stock market awareness has never been higher, and the baby boom generation's need to gather assets for retirement has never been greater. Yet investors are seeking alternatives to mutual funds. Cheap online trading and the lure of quick riches draws some. Wealthier individuals, many of whom amassed their fortunes with the help of funds, now have enough money to hire investment managers to run customized stock portfolios. And many large employers, which adopted mutual funds for their 401(k) plans earlier in the decade, are increasingly casting them aside.

What's wrong with mutual funds? In part, they charge too much for their service, they often stick investors with unwanted tax bills, and the fund companies themselves have flooded the marketplace with products that are often difficult to differentiate and understand. "Investors are confused," says Lawrence J. Lasser, CEO of Putnam Investments Inc. "There are too many funds." But most of all, it's a question of performance. In the greatest bull market in history, the funds have too often failed to deliver the goods.

The mutual-fund industry, which controls more than $6 trillion in equity, bond, and money-market funds, is in no danger of withering away. Funds meet the needs of millions with no interest in online trading or only modest sums to invest. Still, the stocks of mutual-fund companies are underperforming the stock market, and that's a signal that there are problems in the industry. "Mutual funds used to be the investment of choice," says A. Michael Lipper, chairman of Lipper Inc., a fund data and research company. "Now, it's more the investment people use when they have no other choices."

Funds could win back investors if they improved their returns. Sure, over the past five years, the average fund earned 19% a year, a rate at which $10,000 grows into nearly $24,000. But relative to the Standard & Poor's 500-stock-index funds, which don't pick stocks but just buy those in the index, that's woeful. An index-fund investor would have $35,000--a 28.5% compounded average annual return. In all, just 7% of all equity funds beat the S&P over the past five years. Even subtracting foreign and specialty funds, the numbers don't get much better. Just 15% of U.S. diversified funds beat the index.

SKEWERED AVERAGE. Mutual-fund performance has brightened of late, and 1999 was the first time since 1993 that the funds beat the S&P, which earned a 21% total return. Thanks to a boom in small and mid-cap stocks, U.S. diversified funds clocked a 27.7% return for the year. Add in the triple-digit returns earned by many technology and some international funds, and the all-equity average jumps to 31.2%.

But the average is deceptive. The median fund return--half of them did better, half worse--is just 20.9%, which suggests the huge returns of a few funds is skewing the average upward. In most years, the median and average returns are no more than a few percentage points apart.

So why have returns not been better? The most common explanation: The stock market swings back and forth between the large-cap stocks that dominate the index and smaller and mid-cap stocks favored by the mutual funds. The problem was that in the latter half of the 1990s, the swing to large-cap was more prolonged and extreme than in previous cycles.

It's a lame excuse. Fund managers failed to pick up on how the economy and the stock market were changing and how the pricing pressures of a disinflationary environment and increasing globalization favored the very largest companies.

MISSED THE BOAT. Five years ago, only about 2% of the mutual funds had portfolios whose median market capitalization was greater than that of the S&P 500, says Don Phillips, CEO of Morningstar Inc. "So when big-cap stocks led the way, the funds didn't own enough of them." Or even if they did have big stocks, they did not own them in proportion to the stocks' weight in the index.

Those fund managers who caught the big-cap wave--and the subsequent surge in technology stocks, which reflected the information revolution transforming the economy--made bundles for shareholders. Getting those two moves right propelled Janus Funds from a midsize firm to one of the industry's largest (box).

Janus was clearly in the minority. "The fund industry blew the technology boom, too," says Phillips. "You'd be surprised how many fund managers tell us they don't buy technology because it's too risky or they don't understand it. It's like saying: `I don't understand the age in which I live."'

Changing behavior isn't easy. Most funds sell a style of management, a stock selection process, or a discipline that's worked well over time. When it stops working--and that's what happened to scores of value funds over the past few years--the managers usually stick to their systems and wait.

But what if the economy and the stock market have changed in a way that makes the manager's system obsolete? That's a tough call to make, but fund managements need to consider it. "People tend to dismiss what doesn't fit into their models," says Mark Finn, an investment consultant hired by the Lindner Funds last year to overhaul an investment process that was failing. "But you also have to ask if the model is missing something." Finn says he didn't abandon Lindner's tradition of value investing, but "we had to make it more sensitive to current conditions." Robert C. Doll, chief investment officer of Merrill Lynch Asset Management, says following a discipline is important, "but so is bending it when necessary. In a growth-oriented market like we've had, I'm more willing to pay a higher price for a company with good growth prospects."

All told, there's a good case to be made that the funds and the fund industry have been too timid, and funds have under-performed because of it. Not that risk-aversion is a sin. But smart investing is also knowing when to rev up and when to dial back on risk.

Within mutual funds, managers tend to use risk controls, such as limiting the amount of the fund that can be devoted to a particular sector such as technology. If this one fund were your only holding, that may make sense. But most investors today hold multiple funds, and what really counts is not the risk of one fund but how the funds in a portfolio fit together.

BETTING BIG. The truth is risk-aversion may be more a business decision for the fund management company than an investment decision. Fund managers are compensated based on the assets under management, so the incentive is to hold on to what they've got. Sure, if a big bet pays off, the assets will grow and money will cascade into the fund. Missing a big bet will have the opposite effect.

"Fund companies have a basic conflict of interest with fund investors," says Mark P. Hurley, CEO of Undiscovered Managers Funds. "The companies' have an economic incentive to gather and retain assets. Shareholders' interest is maximizing performance."

The interests of the two need to be drawn closer. One way is to put funds on a "fulcrum" fee: The funds win a higher management fee if they exceed a benchmark but give up a portion if they don't. Fidelity, Vanguard and a few others have funds with these incentives, but for the most part they have not been widely adopted by the industry.

And if an incentive fee is good for the fund managers, why not for the independent directors who are paid to represent shareholder interests on boards? Right now, directors are not even required to own shares in the funds they oversee, although an industry task force on directors did recommend last year that they do so.

TOO MANY FUNDS. Another way to improve returns is to shut a fund's doors to new investors before it gets too large to manage effectively. This is especially critical for funds investing in small companies, where too much money crimps returns. At what point does size start to slow the fund? It could be as little as $100 million or $200 million for small-cap funds and several billion dollars for large-cap.

Many funds need to close down--period. John Rekenthaler, research director for Morningstar, estimates that at least half of all equity funds are below $50 million in assets, probably not profitable for their sponsors, and with little likelihood of ever getting much bigger. Liquidating or merging them would go a long way toward cleaning up the clutter of funds that daze and confuse prospective investors and would lower overhead for the firms.

That would give fund companies latitude to lower expenses for shareholders, who by and large haven't benefited much from the economies of scale that go with the sixfold increase in assets over the past decade (chart). The average expense ratio for equity funds is 1.55%, up from 1.45% a decade ago, according to Morningstar. Bond fund expenses have shot up from 0.84% to 1.08%.

Why so high? For equity funds, at least, it's the bull market. With prospects for 50% or 100% returns, who's paying attention? Yet the problem in paying higher expenses is that it does not gain investors anything. "In most industries, you pay a higher price to get higher quality," says Charles A. Trczinka, a finance professor at the State University of New York at Buffalo. "That's not so here." In fact, some fund families with the better returns are also those with lower than average expenses, such as Fidelity, Janus, American, and Vanguard, the company with the lowest cost. Expenses weigh even more heavily on bond funds, where the potential return is in the single digits. No wonder inflows to bond funds have slowed to a trickle over the past five years.

AT WHAT COST? Another reason for rising expense ratios are 12(b)-1 fees. These fees, which show up in the expense ratio, pay for the fund's advertising or distribution costs or to compensate those who sell the fund. These fees can be as little as 0.25% or as high as 1% per year--and they come right out of the fund's assets. For funds that sell through brokers and other intermediaries, these fees supplement or supplant the sales charges, or "loads," which have fallen by more than half over the past 20 years. So the broker's compensation is increasingly coming out of the fund, where in the past the shareholder paid it up front.

This shift distorts the expense ratios, according to the Investment Company Institute, the funds' trade association. So the ICI takes a different tack. It rolls sales charges and expenses together to calculate the "cost" of fund ownership. The ICI also weights the expenses by the size of the fund, so the 0.18% expense ratio for the $104 billion Vanguard 500 Index counts 1,000 times more than the 1.78% expense ratio of the $104 million Phoenix-Engemann Small-Midcap Growth Fund A.

With the ICI's approach, the funds' costs look like they're coming down. The cost of ownership for equity funds dropped from 2.25% in 1980 to 1.35% last year. But it's "consumers who are lowering their costs, not the producers," says John C. Bogle, founder and former chairman of Vanguard Group, a critic of the high costs in the fund industry. Investors do that by putting their money in lower-cost funds, like Vanguard index funds. "There's no price competition among fund companies," says Bogle, who blames this situation, in part, on fund directors who put the interests of fund management ahead of those of the shareholders they represent.

But even using ICI numbers, the drop in the cost of investing in funds looks puny considering how sharply costs on the Street have fallen. For example, technology now enables individuals to trade stocks online for as little as a penny per share. A decade ago, even discounters were charging about 15 cents, and full-service firms, anywhere from 30 cents to 50 cents. It may be unrealistic to think the funds could cut their service costs by that much, since an online transaction is an automated service--and investment management, except perhaps for index funds, is not. But surely, the funds could use technology to give investors a break.

Certainly, separate account management is no less labor-intensive than mutual funds, and the cost of that service is dropping. That has enabled investors with six-figure portfolios to switch from mutual funds to their own customized portfolio of stocks for little or no additional cost.

TAX MAN COMETH. As an alternative to mutual funds, the separately managed account becomes especially attractive in January. That's when the inevitable 1099s arrive in the mail, notifying investors and the Internal Revenue Service of the taxable distributions the fund made the year before--and on which tax will be due. The gains are triggered when managers take profits--a process over which the fund shareholder has no control. Over the past five years, taxes have effectively cost fund shareholders about 2.3 percentage points a year, about 10% of the return (chart). With separate accounts, portfolio managers can work with clients on timing gains to minimize taxes.

Mutual funds have no choice about distributing their gains, but critics argue they don't do enough to lower them. One way is through better bookkeeping. Just as a tax-savvy investor would reduce the size of a profitable block of stock by selling his highest-cost shares, fund companies need to do the same. Yet not all funds follow the "highest in, first out" accounting. They should. Joel S. Dickson, a tax specialist at Vanguard, says studies show that HIFO accounting can save shareholders as much as 1% a year in costs.

Another way to cut the tax bill is to trade less often. The average equity fund has a turnover rate of 90%, which means that a $1 billion fund does about $900 million worth of trades each year. Besides triggering gains, trading incurs commission costs of about 5 cents a share--that's much higher than most individuals pay for online brokerage. Why so high? In part, by paying higher commissions, investment management companies can also use some of the commission--called "soft dollars"--to pay for research, data services, or even newspapers and magazines. Think of it this way: It's sort of like frequent-flier miles for the fund managers, except they use the shareholders' money.

SHAKING THE MARKET. Commissions are not the only costs involved in trading--there's also what is commonly called "market impact cost," an additional cost incurred when the fund's buy or sell order itself changes the price of the stock. For example, if a mutual fund wants to sell a large block of stock, it may have to accept a lower price in order to do the trade. Likewise, if the fund is shopping for a large block of shares, it will have to pay more for it.

Market impact cost is not something you find in a fund's financial statement. But it can be detected through analysis of the trading records. The cost to shareholders can be high--1% to 5% a year, depending on the size and liquidity of the stocks that a fund trades and the style of trading. Funds that invest in small-cap stocks have higher impact costs than those that buy large-caps, says Nicolo Torre, a managing director at BARRA Inc., an investment consulting firm. And funds that practice a momentum strategy--buying what's hot--usually end up paying more than value investors that buy and hold. The only way to cut market impact costs, he says, is through fewer trades. "Ten percent of the trades reflect 90% of the market impact cost," says Torre. "Halve the number of trades, and you can significantly lower the fund's market impact cost."

Trading behavior is not only dependent on the portfolio manager's investment decisions. Sometimes shareholders rushing in or running out will force the manager's hand. Certainly, that's the case with Internet funds, which likely bear a huge market impact cost for buying thinly traded Internet stocks in a hurry. Of course, the returns have been so large that the cost is hardly noticed. However, if the Internet stocks tank and the funds are hit with a wave of redemptions, the impact cost will be huge--and without any gains to offset them.

MAKING PATIENCE PAY. Mutual funds have become more sensitive in recent years to traders who dart in and out of the funds. In some cases, the traders have been booted out, and in others, redemption fees have been instituted to discourage short-term switching. Industrywide, redemption rates are on the rise.

Slowing down the trading would also enable funds to be more fully invested and keep less cash in the till for redemptions. That cash is a drag on performance, since it earns less than it would if it were invested in stocks. Over the long haul, lower cash levels should improve returns.

Mutual-fund companies are quick to point their finger at such bad practices of investors as excessive trading in and out of funds. The fund companies could do more to encourage good investor behavior, however. One idea: Create a separate class of shares for investors who have been in the fund for, say, five or ten years, a move that would allow the fund company to give the shareholders a break on expenses. Or, asks SUNY's Trczinka, what about giving a special dividend--payable in shares only--to long-term investors on the anniversary of their investments?

That could help improve the relationships between fund companies and their investors. But it's not a substitute for what really needs to be done: cutting costs and raising investor returns.

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