The Advantages of Investing in Mutual Funds

The old guard firms, banks, retail brokers, and hobby investors are competing against the Fidelity's of the world, trying to guess what Fidelity will do next. In the meantime, the mutual fund giants are adopting new technology to reduce commissions, cross shares, and lower transaction costs even further. They are opening overseas offices from which to expand their global presence. The world has changed. Mutual funds are the victors. Savvy investors will take advantage of the opportunities created by this new reality.

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Forget the mutual fund scandals that helped Elliott Spitzer win the Governor’s office. Were there some dunderheaded mutual fund companies out there who sacrificed retail investors in order to bring on more assets? You bet! There are idiots in every profession, and a hungry marketing executive at the helm can ruin just about any business. For retail investors, however (and that means anyone with less than $10 million to invest), mutual funds remain the most economical way to access professional money management talent.

Many mutual fund companies now have access to better research than the sell-side investment banking houses that make millions of dollars underwriting (manufacturing) and selling new stocks and bond issues. The big corporate underwriting clients put a lot of pressure on analysts to keep a positive recommendation on their stocks. A large corporate client concerned about the negative opinion an analyst has on its stock can get an appointment with the investment bank's Chief Executive Officer and will be able to air its concerns.

"I was sweared at, yelled at and screamed at and told to clear out in two hours," says Ronald Baron (portfolio manager for the highly successful Baron Asset Fund), describing his first job as an analyst for the branch office of a regional brokerage firm. He'd made the mistake of writing up - and panning - one of the firms underwriting clients. It doesn't happen all of the time. And it doesn't happen everywhere. But it happens often enough. If you want to avoid this conflict, like Ron Baron you might have to abandon the old system and join the new world of mutual fund investing.

Mutual funds also benefit from being able to execute trades at a fraction of the cost faced by individuals. They get research from all of the top brokerage houses, not just one, and can subscribe to investment databases that can cost more money than most individuals make in a year. Even in the small trust company I joined, we spent more than $100,000 a year on getting information to our desktop. (And that firm was positively primitive compared to what most of our competition was getting.)

Competing against these professional investors is a "Loser's Game." Trying to outsmart them is a little like trying to out-shoot LeBron James on the basketball court. It could happen, I suppose, but the law of averages combined with the fact that he practices more, has more experience, has more support resources and probably more at stake in the matter suggest that it's a long, long, long-shot.

Investors need professionals on their side – to act on their behalf. Just as Charles Schwab took their side in the trade execution business, resulting in dramatic reductions in the price that investors pay for commissions to buy or sell shares of stock, investors need an agent on their side to research individual investments on their behalf. They need a separate, independent agent to help them monitor that program and evaluate its success.

It may be heresy, but the most economical way to find this buyer’s advocate for retail investors is through a mutual fund company. Ultimately, fund managers are mostly on the same side of the table as investors. The managers want to put together a great track record because that is what sells. Since funds are paid as a percentage of assets under management, a large fund pays its manager much better than a small fund. Manager fees are often about one-half of one percent (0.5%). On a $10 million fund, this is about $50,000 and wouldn’t pay for the office space. On a $1 billion fund, this amounts to $5 million and covers country club dues both at the main homestead and at the beach house as well.

In the world of mutual funds, performance is almost everything. This means that for the most part, investors and their hired guns have similar goals. They are truly sitting on the same side of the table. This is a huge advantage over a traditional brokerage relationship in which a trusting client sits opposite the financial product salesman and hopes that the nice, personable individual sitting across the table will ignore the myriad of financial incentives to sell him too little for too much.

I first wanted to write this book in 1997. A decade ago, however, investors only knew up markets. They thought their broker was a genius, when it was really just a rising market that was making the broker look good. Indexing was the rage. The books were mostly about how active money management was a waste of time. The technology bubble was merely a gleam in the eye of a couple of young Janus Fund portfolio managers while everyone else talked of “efficient markets.” Elliott Spitzer hadn’t collected a billion dollars in penalties from Wall Street. Silicon Valley hadn’t yet pumped and dumped itself a fortune. In short, nobody cared about Wall Street’s inefficiencies during the good times.

Since that time, however, the stock market has only appreciated about 6% a year, far below investors’ retirement assumptions. Fortunes have been made and lost, but insiders have been making most of the money while retail investors have been funding those fortunes. Investors are frustrated by the dishonesty at Wall and Broad. Wall Street and Fortune 500 execs, internet company founders and venture capital investors cashed in by selling high hopes to excitable investors. But who was looking out for the interests of investors during this roller coaster?

I would have thought that by now the Wall Street hustle would be on its last legs. Instead, it has reinvented itself as a purveyor of outside managers and, the ultimate, of exotic hedge fund strategies. I would have thought that by now this book would have been written by a half a dozen other authors. I can hardly believe that the myths which so irritate me are still accepted as fact to the detriment of millions of investors nationwide.
If your advisor hasn’t challenged these myths, then maybe it’s time you changed advisors. The Catholic Church didn’t give up its practice of getting paid indulgences on its own accord. It was faced with a certain inevitability. Some realized the world had changed and move quickly. Most drug their feet, with those beneficiaries of deceit moving last of all. If you’re waiting for your broker to tell you the gospel truth about why your investment program isn’t working, you’re on a quest for financial martyrdom. Is that really the end result you had in mind?

Next post: A New Era: How Supermarkets De-Throned Wall Street

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Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Most Local Advisors Can’t Compete

I used to work for a bank-owned advisory firm which competed with the mutual fund behemoths of the world. While we had decent performance during my tenure there, a depressing reality haunted me because I knew that in the long run there was no way that we could compete effectively with our mutual fund competitors.

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We were a small trust department. When I joined the shop, we had 1,800 clients and about $300 million invested in our trust department common trust funds (which are like mutual funds except that they can only be used by internal trust department clients). We managed three stock funds and four bond funds. When I arrived in at this shop in 1995, the bank's long-term investment record was pretty sad. During the previous five-year period, while stocks generally were increasing 15% a year, the bank’s stock portfolios were appreciating at a 10% clip. While some investors were pleased by double-digit returns, more knowledgeable investors were beating us up (and closing their accounts) because of our underperformance relative to the broad market. By the time I got there, only "brain dead" clients, who didn't know enough about investing to know that they should fire us, remained.

We junked our existing stock selection process which picked stocks by committee. Instead, a single portfolio manager was assigned to manage our stock portfolios, and another portfolio manager was picked to manage most of our bond funds. Portfolio managers were given authority and accountability for their decisions. The frightening part was that these fund managers had no staff support, inadequate technology, and no analytical support. Moreover, these individuals were also assigned various other duties. Our bond fund manager also coordinated mutual fund company relationships. Our equity manager also traveled throughout the Ozarks to meet with clients and prospects and was also required to participate in various administrative meetings. He had no analysts researching investment alternatives. Because of his other duties, he was not even a full-time portfolio manager although we did the best we could to protect him from the bank's substantial bureaucracy.

Contrast this structure with that of a good mutual fund company. The mutual fund company has several analysts who usually specialize by industry. These analysts research individual companies. The analysts read the financial press, have access to the research of numerous Wall Street brokerage houses, and read the industry trade journals as well. A large fund company will have little problem getting access to senior management at a company. Frequently company management, and Wall Street analysts, will travel to the fund company's offices for presentations. Analysts have the freedom to travel to industry conferences, call on customers and visit company sites. They research that firm, and its competitors. This information is synthesized and summarized for the benefit of the portfolio manager, who must decide whether or not to invest in a particular company's stock.

A small shop has essentially a part-time portfolio manager who barely has time to keep track of his own current investments, much less evaluate new ones. Many small investment shops claim to visit company management and research company customers and the competition. Few actually do it. I was embarrassed when senior managers of our bank sometimes made such representations to clients and prospects. Aside from our portfolio manager's frequent trips to McDonald's, however, I can't really say that I ever saw us do these things. Small shops can't afford to!

The industry has changed dramatically from the time when a "customers man" (what they used to call brokers sixty years ago) sold stock to individual investors. These brokers offered clients recommendations which were guided by the stock broker's research department, which maintained proprietary research data. Now, however, the sort of information over which retail brokerage houses once had exclusive domain is easily attainable by anyone with a computer. The competition for information has become intense. It is no longer sufficient to be able to retrieve the data, now the spoils go to those who get it first. Whoever gets the "first call" has an opportunity to cash in on big news. Anyone else is too late.

Local trust companies, individual brokers, small investment shops and certainly individuals play second fiddle to the fast growing and cash rich mutual fund and hedge fund complexes. These institutional investors are generating enormous commissions, even at extremely low institutional commission rates. These commissions entitle them to special consideration.

With more than $3 trillion under its roof, if Fidelity wants its brokers' analysts to give them a first call on new recommendations, Fidelity gets it. By the time that a retail broker gets the story explained to them, Fidelity has already decided whether or not to invest a part of its treasure chest in that idea. (In other words, it's too late.) In fact, Fidelity's own marketing blitz emphasizes this factor. Several years ago the company set the advertising industry abuzz by creating commercials which aired each night that included the day's headlines in them. The commercials implied that for viewers, the headlines are news. For Fidelity, they're history. Fidelity's analysts have already anticipated the news and its consequences, watched the story unfold, and traded securities based on the news long before retail investors even heard the headline.

Fidelity brazenly asked for and received access not only to brokerage analyst reports and recommendations, but also to the spreadsheets which the analysts use to develop their conclusions. And Fidelity didn't just ask for a copy of those worksheets. Fidelity was able to get permission to go online and look at the analysts' worksheets live, via an internet connection. No retail broker in any company would receive permission to inspect its analysts’ spreadsheet assumptions.

SAC Capital Advisors is a multi-billion dollar multi-strategy private asset management firm founded by Steve Cohen in 1992. SAC trades so frequently and aggressively that on some days SAC is said to comprise a meaningful percentage of daily trading volume by itself. If there is an analyst on Wall Street with anything meaningful to say, which is in and of itself a questionable premise (but I’ll leave readers to Andy Kessler’s “Wall Street Meat” to address that question) then SAC has heard the news and traded on it before your local broker has even opened his Outlook software to glance at the morning e-mails.

Next post: The Advantages of Investing in Mutual Funds

To start at the beginning of the Investment Heresies eMag, click here

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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Local stocks rise while broad market falls

The Scout Partners Index of Western Colorado stocks rose +1.72% while the broad market fell -3.25% in February (total return including dividends). The 25 stock index focuses on large companies whose operations have a significant impact in Western Colorado. It includes major Mesa County employers such as Wal-Mart, Halliburton, Kroger (City Market), Exxon Mobil, StarTek, CRH (United Companies), and the Union Pacific Railroad.

Natural gas prices rose and many local energy companies were up 10% or more during a month where the broad market indices continued their 2008 declines. B.J. Services (BJS) rose +19.4% in February, but close behind were Arch Coal (ACI), +16.4%, Halliburton (HAL), +15.7%, Encana (ECA), +15.1%, Williams (WMB), +12.7%, and Bill Barrett Resources (BBG), +11.2%. Doug May, President of May-Investments, a Grand Junction-based registered investment advisor, noted that, "natural gas prices have reached their highest prices in 26 months but investor sentiment about the sector remains pretty cautious,” May said. "Gas inventory levels remain under control and the lower drilling rig activity we've had over the last year suggests that inventories will decline from here." Concern about a possible recession is overshadowing the positive industry fundamentals, however, so valuations in the sector remain depressed.

Mesa Air Group (MESA) was the worst performer in the index, falling -31.1% in February. The stock closed the month at $2.42 and has fallen 68% in the last 12 months. Mesa was as high as $12.87 as recently as 2006, recently re-signed several senior executives to long-term contracts to reward them for their service to the struggling carrier.

"High energy prices have hurt Mesa," May observed, "and the company reported a $2.8 million loss mid-month on lower revenues and higher legal expenses. Including losses earned at its Air Midwest subsidiary, the company managed to lose $4.2 million." Mesa Air Group has announced that it is selling the money-losing Air Midwest subsidiary. "Mesa said that it is planning to boost its cash reserves by financing its spare parts inventory," May noticed, "which makes investors feel good until they realize that it's sort of like an alcoholic taking out a home equity loan to put money back into the family bank account, nor does it make me feel better about climbing onto one of their planes which might be needing one of those spare parts to stay right-side up."

Scout Partners equal weighted index of Western Colorado Stocks is comprised of 25 stocks that hope to reflect, to some degree, business conditions in Western Colorado. Reflecting the local economy, the index has a large (over 30%) concentration in the energy sector, which tends to drive index performance. The next largest sector concentration is in Industrial stocks, which comprise over 20% of the portfolio. Local stocks are up +6.9%% over the past 12 months while the overall market has returned -3.6% over the same time period.

Douglas B. May, CFA, is President of May-Investments, LLC and author of Investment Heresies.

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