Lee Wenzel

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Mutual Funds

Tragically, most Americans invest loyally in mutual funds through their retirement plans and do not have returns that match the market indexes.  This section itemizes some of the detrimental dynamics of mutual funds, and why we present a  money management alternative to mutual funds by directly owning stocks.

Disadvantages of Funds in IRA or Qualified Accounts

  • High Expenses

Mutual fund expenses are significant and mostly invisible.  Different sources report average mutual fund expenses ranging from 1.7% to 2.38%.  Few mutual fund owners are aware that depending on how long a fund is held, no-load funds may be more expensive than funds with a sales load after considering the annual operating expenses (AOE).  Transaction costs are extra and not published.  The high compensation for money managers is not published on mutual fund information sites, and is difficult to find.  A recent supplement to the prospectus for Seligman Global Fund Series, mailed as an accompaniment to a required vote on a change in fund management, revealed that “the Manager receives a fee equal to an annual rate of 1.00% of the average daily net assets on the first $1 billion of net assets under management, ...”  That is ten million dollars to manage a portfolio!  The number of positions is not that different from what we manage, and the returns are inferior.  The manager qualifications were in rather general terms, i.e. 15 years of experience, with no mention of performance. 

Mutual fund board directors often receive $150,000 a year for services requiring a few hours.  There are frequent conflicts-of-interest and a lack of rigor in selecting management teams. 

  • Poor Performance

The performance of most mutual funds is poor.  Fewer than 20% beat the market in any given year. Even fewer do so consistently.  Success in recent years usually predicts lack of success for the immediate future.

  • Manager Constraints

Fund managers operate under significant constraints.  They are expected to stay invested and within their prescribed style, even when enduring a bear market for that style.  If fund managers do stray from their prescribed style, this confuses the owners’ asset allocation. 

The breadth of the market opportunity open to the manager is restricted.  Because of the significant dollars they need to invest, most fund managers are restricted to stocks trading with high volumes.  When needing to invest millions, dealing in smaller stocks would drive up the price when buying and drive it down when selling.

  • Holdings Unknown

The fund buyer has no way of knowing what positions are currently held by the fund.  For competitive reasons, funds do not publish a list of current positions.  Such information is usually a couple months old, or only for the top holdings.  One consequence is that the investor seeking to diversify with multiple funds may unknowingly be heavily invested in a small number of stocks duplicated in each fund.  Another consequence is that it is difficult to do social investing or not own specific companies, such as investors wanting to avoid companies in gaming, tobacco, sub-prime lending or that are environmentally irresponsible.

  • Corporate Control Wrested from Investors

Mutual funds are the owner of record for the stocks held in American companies, rather than the individual investor whose money is invested in the stock.  A recent newspaper article reported that the 75 largest mutual fund companies control 44% of the voting power at American companies.   The democracy of American capitalism is hampered and corporate accountability to the real investor is severed because the mutual funds vote the corporate shares instead of the underlying investor being able to vote the shares.

  • Conflicts of Interest

Mutual funds are embedded in many conflicts of interest.  The recent scandals within prominent corporations can be partially attributable to the weak corporate governance resulting from mutual funds having sweetheart deals with the companies whose shares they own.  For example, fund companies administer 401(k) and 403(b) plans as a way to market their funds.  In return for such contracts with employers, the fund company buys that company’s shares for its portfolios.  The financial analysts influenced by consulting incentives are not alone in having conflicts of interest when evaluating stocks for purchase.

  • Selection is Difficult

Mutual funds are more difficult to select and own than stocks.  There are more mutual funds to choose between than stocks.  In selecting stocks, more empirical data are available than for picking a fund.  Purchasing decisions are mostly limited to evaluating the fund's style, its manager and its history.  Most funds can only be purchased at the end of the day.  Many carry significant fees to buy or sell, or have constraints on the frequency of trading. Today, diversification is easily and economically available without turning to funds.

  • No Control over Fund Changes

Mutual funds lack assurance of stability.  Funds are often acquired or merged, giving the investor a different package than originally selected.  There may be frequent changes in fund managers.  Yet, the fund manager is perhaps the most significant variable in picking a fund.  The manager can leave; the fund holder often cannot without fees and penalties – if they are even aware of the change. 

Additional Disadvantages in Non-IRA Accounts

  • Complex Tax Filings

For accounts paying taxes, the tax accounting is more complex for funds than stocks, with all the distributions and details of stock transactions that must flow through to the individual fund holder’s income taxes.

  • Capital Gains Taxes Even When Losses

The fund owner lacks control over capital gains.  A fund may need cash shortly after one buys into the fund or sell a position for other reasons.  The stock being sold by the fund may be up considerably from when purchased even if the net asset value (NAV) of the fund is down significantly from when the shareholder purchased it.  Therefore, as an investor, one may be hit with a loss on the NAV of the fund while at the same time having to pay for capital gains that accumulated for years prior to buying into the fund.  The fund manager controls the timing of taxable events.  The investor’s only choice is whether to sell the fund, or to try to buy tax-efficient funds. 

  • Tax Write-offs Often Lost

Shareholders often lose the tax benefits of mutual fund losses.  A mutual fund can use losses to offset gains for only the next 8 years, while individuals can carry a loss forward indefinitely.  There are several implications to funds being “pass-through investments”.  When a fund goes in the dumper, the pass-through benefit stops; tax-loss carry-forwards stay with the fund, instead of exiting with the shareholder.  If funds merge, funds with losses can’t take all of their losses with them.  Realized gains are distributed, realized losses stay with the fund.  (See Seattletimes.com, “When fund investors lose, it’s tough for them to win” by Chuck Jaffe, senior columnist, CBS Marketwatch, 2/26/03.)

  • Long-term Holders Pay Short-term Capital Gains

Because of turnover in fund positions, one may often pay short-term capital gains even if one is a  long-term holder of the fund.

How well have your funds performed?

While these are only a few of the detriments to mutual fund ownership, hopefully enough reasons were given to cause you to take a serious look at why anyone should hold mutual funds.  Do you know how the performance of all the funds you have held has compared to the market?  If not, I can help you figure it out.  Will you continue to choose to hold funds, or are you moving into alternatives?

Should Wenzel Analytics Offer a Mutual Fund?

  • Diversification Without Mutual Funds.

A frequent first comment when people come to Wenzel Analytics workshops is that the money management service is like a mutual fund.  At first I was insulted, in view of the reasons to not use mutual funds and in view of the recent publicity on mutual fund scandals.  Then I began to realize that for many people, diversification and mutual funds are seen as synonymous.  Mutual funds have become an implied and assumed way to invest.   Most people do not realize the implications of what is made possible by trading online at $7 a transaction.

The second comment I hear, after they see my results, is that I should form a mutual fund.  People continue to automatically see mutual funds as the way to invest. People respond to the scandals of the financial industry similarly to how people respond to their dissatisfaction with American healthcare.  The system is often seen as terrible in its inability to perform at a reasonable cost, while people’s personal physician and care are seen as great.  Mutual funds in general are terrible, but individuals have confidence in their personal financial advisor and the funds in which they are invested.  We all resist seeing ourselves as the victim.

  • The Internet Has Replaced the Need for Mutual Funds

I resist setting up a mutual fund because I know it is the mutual fund system which is the problem, not the malfeasance of a few individuals. 

Apart from all the reasons given here to not invest through funds, funds change the relationship between us.  What is now a service to specific individuals managing their personal resources becomes a thing or commodity that you purchase.  As a money manager, I would lose that connection with the person whose money I manage and the responsibility for how that money fits into their life goals and requirements.   My service would become an impersonal product that others would buy and sell.    

 

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    Eden Prairie, MN 55344

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    Lee@WenzelAnalytics.com