Mutual Funds Confront Not-Quite-as-Dumb Money

Photograph by Victor J. Blue/Bloomberg

It used to be easy—and I mean Uncle Pennybags-laughing-to-the-bank easy—to be a mutual fund. During the heyday of the cult of equity, investors would dutifully chase returns at Fidelity, Janus Capital, Munder NetNet, or whatever was the performance flavor of the year.

Fund companies would dock investors lucrative, but rather imperceptible, fees for the privilege of running that money—though more often than not without delivering superior returns. But that’s OK: Why sweat a point or two of slippage in a go-go bull market that returned in the teens practically every year?

Obviously that zeitgeist no longer represents the world we live in. The stock market is still recuperating from a meltdown and lost decade that was its worst since the Depression; outflows from equity funds remain the order of the day. Still, the industry isn’t quite panhandling: At year-end, the domestic mutual fund market lugged $11.6 trillion in assets under management, according to the Investment Company Institute (PDF).

And it remains quite a durable business. About 80 percent of actively managed mutual funds underperform the market in a typical year. Investors who stick with them pay much more than they have to. The pennies really add up—like so many little golden crumbs in The Bonfire of the Vanities (thank you, pre-fame Kim Cattrall and Kirsten Dunst). See this telling bit from the study Tyranny of Compounding Fees: Are Mutual Funds Bleeding Retirement Accounts Dry?:

“If mutual funds underperform the Standard & Poor’s 500 index by [2.5 percentage points] annually, then after 10 years the financial services industry gets about 46 percent of the market gains on average, leaving the investor with 54 percent. Mutual fund investors fare considerably better when the level of mutual fund underperformance is only [half a percentage point] annually—investors receive on average 82 percent of market gains over a 10-year time frame. As the investment period lengthens, the proportion of market gains that go to the industry becomes larger. For example, if mutual fund performance lags that of the S&P 500 by [2.5 percentage points] annually over a 50-year investment period, the financial services industry captures about 74 percent of the market gains on average. If the performance lag is only [half a point] annually, then the proportion of market gains accruing to the industry after 50 years is about 23 percent.”

Just one reason why traders and financial heavies deride oblivious retail investors as the “dumb money.”

But at last there’s some modicum of revenge for this long-abused constituency. An analysis by Russel Kinnel of Morningstar notes that the average investor is now paying a little less for open-end mutual fund management: 0.75 percent vs. 0.77 percent in 2010. Mind you, that’s still much higher than it has to be when ETFs and index funds are knifing at one another to drive expenses well below 0.20 percent, and even 0.10 percent.

But another key trend suggests mutual fund investors are actually wising up and taking action. Kinnel grouped mutual funds into quintiles based on their fee level relative to their category peer group. He discovered that the cheapest quintile funds drew $122 billion in net inflows in 2011. All other quintiles had net redemptions, with the next cheapest posting $14 billion in net redemptions, the middle losing $21 billion, the fourth losing $18 billion, and “the most expensive quintile with an average expense ratio of 2.12 percent saw $13 billion walk out the door.”

In its own study, Vanguard, the index fund pioneer and inveterate cheapskate, finds that this vigilance toward cost has been occurring over a longer period, across both conventional mutual funds and ETFs: “The lowest-expense-ratio quartile attracted more than $360 billion, or 100 percent of the positive cash flows into equity funds, for the ten-year period. Higher-cost quartiles collectively suffered cash outflows of more than $293 billion over the same period.”

It makes too much sense, really, that more investors are waking up to appreciate the cumulative value of fractions of points. With the Fed at emergency interest rate policy, many Treasuries yield less than inflation. Banks are paying less than a point—if anything—for your cash. Year in and year out, you expect to be increasingly nickel-and-dimed for less health coverage. You’ve learned to pay more for the cup of yogurt or bottle of shampoo that is a fraction of its old size. Should the multitrillion-dollar fund industry be immune to cheap?

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