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