Week 38: Mutual Funds, A Death by A Thousand Cuts

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The Markets

The S&P 500 (i.e., the “market”) is down a little more than 6% this year, excluding dividends.  Last week they fell around 1.4%.  The healthcare sub-sector, a shining star this year, up 20% as recently as August, is now only up around 5% for the year.  Hillary Clinton’s tweet on biotech "price gouging" perhaps didn't help matters for this potentially “bubbly” sector.

So Fed Chair Yellen decided not to raise rates which is precisely what many pundits wanted.  So how do you explain the breakdown in the market?  Perhaps, the market knows something that these pundits do not?  Wisdom of Crowds, anyone?  Our more nuanced views can be found in this August 30th post. 

So are we in a bear market? 

Its hard to say.  On the one hand, it seems that monetary policy (“QE”) has reached the point of diminishing returns and valuations without earnings growth appear stretched.  So perhaps its time for some old fashioned fiscal policy, and infrastructure spend?

We find it much easier, especially in markets such as these, to have a more informed view on individual stocks.  What can they earn? What are they worth? Are they over- or under-valued?

And with the benchmark 10-year Treasury note still yielding around 2%, a principal-protected 5% dividend yield portfolio looks attractive to us (see here for more on our model portfolios).

Staying with our theme of smart people doing dumb things…

The other day, I was chatting with someone in our large extended family.  He works long hours and has no time to manage his own money.  He wants to save for when his son is ready for college.  He doesn’t want to open a 529 college plan because he wants to provide his son with greater financial flexibility.  So his financial planner / fishing buddy puts him into a mutual fund. 

The allure of mutual funds to the retail investor:

  • Familiarity:  Mutual funds are usually the first investment vehicle that working professionals are introduced to through their 401k. 
  • Choice:  Mutual funds are available for any and every theme one can imagine.  From old school, "growth" vs "value", to sector-based to “target date” to the all encompassing “opportunity” fund. The wide variety of options can rival the menu at a Vegas lunch buffet.
  • "Professionals" managing your money:  For students of the Behavioral Sciences, this would be the Principle of "authority" from Dr. Cialdini’s Theory of Influence.

Mutual funds – so how can you possibly lose?

Here's how: 

  • Fees, lots of fees:  You have front-end loads, back-end loads, and 12b-1 asset-based fees.  These are just the sales related fees. They don’t even include the ongoing fees such as those charged by the investment manager to manage your money.  There’s a good reason why those disclosures are so many pages long.
  • Serial under-performance:  There is research aplenty on this subject so I’ll keep it brief.  The intuition is simple.  If one owns a basket of 100+ stocks, the fund begins to mimic the performance of the benchmark index, before costs. Once you add on management costs and transaction costs under-performance is all but assured.
  • Punitive tax consequences:  While mutual fund taxes can be downright insidious, they are rarely understood by retail investors.  Let’s begin with a concept called "capital gains distributions."  It occurs when a mutual fund sells stocks that have appreciated a lot.  So far so good.  Say you invest $50,000 into a mutual fund just before it makes a capital gains distribution.  Here’s the rub: you could be on the hook for taxes on those capital gains even though you weren’t in the fund long enough to benefit from those gains.  If the fund realized a 10% capital gain, as a new investor you may still have to pay taxes even though your $50,000 investment did not appreciate 10%.  Think about that for a minute.  For more on this, please refer to this excellent Morningstar article.

I can't think of an  investment management firm that hasn’t entertained the idea of launching a mutual fund.  It is such an attractive investment vehicle… for the money manager (not so much for investors)!



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