Inside The Great Mutual Fund Trap

In their provocative new book, two U.S. Treasury veterans use exhaustive research to challenge the concept of managed funds

By Amey Stone

After the fall of Enron, WorldCom, and Jack Grubman, highly regulated, broadly diversified mutual funds seem pretty benign. After all, investors in the average diversified equity fund have lost only 15% in the past year, or an annual average of 6% for the past three years. Those numbers looks pretty good compared to the carnage suffered by Enron employees enrolled in its pension plan or holders of WorldCom stock.

Nonetheless, amid the fear and blame that have replaced the irrational exuberance and greed of the late '90s, the mutual-fund industry is due for a hard look. And that's what it gets in The Great Mutual Fund Trap (Broadway Books) by Gregory Baer and Gary Gensler, former officials of the U.S. Treasury. Among Treasury's responsibilities is the regulation of financial-services firms, so the insights the authors gleaned as watchdogs give this well-organized, well-researched book a heft that many investment primers written by fund-industry insiders typically lack.

So what's the authors' beef? For veteran mutual-fund investors, much of their critique will be familiar. Baer and Gensler argue that the great majority of actively managed mutual funds fail at their implicit promise to beat broad market returns. Fail abysmally, in fact.


  According to the authors' exhaustive research, over every five-year period only about 20% of actively managed mutual funds perform well enough to make up for their fees and expenses. And not only do most funds underperform the market but they do so while taking more risk than passive indexed investments. That means investors often experience high volatility while suffering poor returns -- a charge many fund investors today can certainly relate to.

Furthermore, the chances of picking a winning fund are slimmer than you might think. The authors show that funds that outperform for one five-year period are likely to underperform for the next five years (all of Baer and Gensler's assertions are backed by references to academic studies or research reports, usually two or three of them). Mutual-fund managers who are able to beat the market temporarily and then boast of their latest picks on TV are nothing more than "coin-flippers of the month," the authors say (see the accompanying excerpt of Chapter 1, "Money Management In a Nutshell").

The long-term success of a handful of money managers, such as Bill Miller of Legg Mason, is nothing more than the law of averages at work, the authors argue. As radical as this charge may seem to those reading it for the first time, it's widely embraced by many academics schooled in the "efficient-market theory." This theory postulates that markets are so efficient that at any given time all stocks are priced right where they should be, so picking one stock to rise more than another is pure guesswork. Of course, legions of Wall Street soldiers are ready to argue the contrary position.


  Actively managed funds aren't the only object of Baer and Gensler's criticism. They also challenge the whole idea that investors should even attempt to exceed market returns. The book critiques market timing, day trading, and stock-picking -- all practices that lead investors to spend more on fees and usually earn less as a result.

So if trying to beat the market is so futile, who benefits from an investing world set up to encourage individuals to attempt it? Clearly it's the mutual-fund companies and Wall Street firms themselves, Baer and Gensler say. They cite estimates that stock and bond funds reap $70 billion a year in fees. About $20 billion goes to the brokerage industry to cover the costs of the trades. The authors lament the marketing messages -- both from paid advertising and from talking heads interviewed on TV and in print -- telling individuals to "trust the experts," "trade frequently," and try to "beat the market."

The Great Mutual Fund Trap is most provocative and entertaining when hinting at this larger conspiracy. But after ripping apart the fund and brokerage industries in the first half, the second half of the book turns into essentially an investment primer. The advice is solid. It boils down to advocating that investors choose passively managed vehicles like index funds and exchange-traded funds (a new kind of index fund that trades like a stock on exchanges).


  Investors are exhorted to seek out offerings with low fees and expenses. Vanguard Total Stock Index and 500 Index funds are the authors' favorites. They also encourage investors to focus on asset allocation, buy bonds directly from the government, and invest in tax-advantaged accounts like Roth IRAs for retirement and 529 plans for education expenses.

With a light touch and a conversational tone, Baer and Gensler do an admirable job of maintaining a quick pace. But the book can't help but feel like homework at times. To their credit, the authors are well aware that they aren't offering the most exciting of investment strategies. In the authors' note they write: "Here's a good rule of thumb: if you're having fun investing, then there's a good chance that you're not properly diversified, you're trading too much, and you're taking too much risk." They're brave to title the nuts-and-bolts section of the book quite honestly: "Passive Investing for (Less) Fun and (More) Profit."

What might have made The Great Mutual Fund Trap a bit more appealing is if the authors could have allowed that, for at least a small portion of their portfolios, some investors might find it fun, challenging, and even rewarding (if just on an intellectual level) to pick their own funds and stocks. In an investing climate as brutal as we've seen over the past two years, it's easy to forget that investing can be fun, and the readers who will appreciate this book the most are likely those eager to put their stock-picking days behind them.

The Great Mutual Fund Trap has a decidedly anti-Wall Street message that's well in keeping with the spirit of the day. Baer and Gensler offer sound advice with good cheer, even though they admit what they're really trying to do is take all the fun out of investing. For investors still suffering a hangover from the bull-market party of the late 1990s, this book is medicine that should be quite easy to take.

Stone is an associate editor of BusinessWeek Online and covers the markets as a Street Wise columnist and mutual funds in her Mutual Funds Maven column

Edited by Patricia O'Connell

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