Young and Invested

In 2006, mutual funds were owned by approximately 54 million American families. They were originally created with a purpose of making investing in diverse industries more affordable with a smaller amount of capital. Since they are managed by professionals, very tightly regulated by authorities, cheap and diversified, many think that mutual funds are the perfect investment vehicle.

But they are not perfect.

Mutual funds, if almost perfect, are far from the ideal investment, and because of their inherent disadvantages, most mutual funds under-perform the general market, charge inflated management fees and suffer volatile performance swings.

Inherent Flaws

Firstly, the very tight regulations set onto mutual funds by authorities actually end up almost hurting them. As Peter Lynch mentioned in his famous book, “One Up on Wall Street”, these regulations often restrict a fund from owning more than a certain percentage of any holding (for example, max 5% of outstanding shares of Amazing Company Inc.) or restrict a certain holding from eating up too much of the fund’s funds (for example, only 5% of total capital can be used for Profit Company Inc.). So if a mutual fund manager actually a few really good plays, they often have to compose a very small proportion of his portfolio and he may not be able to take full advantage of the purchases. This is mutual funds, as you may know, often own hundreds of different equities.

Secondly, equity investements in mutual funds are very focused on image rather than fundamentals. As evidenced by a popular quote in the mutual fund industry: “You’ll never lose your clients losing on IBM”. This indicates that a mutual fund with investments based on popular names and fast-growing companies will often not be as critically assessed if their fund produces small or negative returns; investors will just ask “What’s wrong with that IBM lately?” instead of asking “What’s wrong with you?”. Investors and managers reviewing the holdings of the mutual funds will often want to see big and popular names, instead of small and medium-cap companies that in fact may end up being highly more successful.

What is also very important to note is that succcesful funds often do not stay successful for long. Producing high returns in the mutual fund business can actually attract recruiters to those gifted mutual fund managers (this is more common than you might imagine). Furthermore, it will attract new investors to those mutual funds, which leaves the managers with the option of investing in their current successful holdings at a now higher and likely inflated (by a few hundred million dollars of inflows) prices or simply trying to find new investments which may not end up as successfully as the past winners. And lastly, higher returns will almost certainly lead to higher management fees and therefore to timid behaviour by those successful managers, who are now trying to be more conservative with their equity picks to avoid volatility and justify the higher management fees.

Is All Hope Lost?

When you add up all these factors, it’s not a wonder that a majority of mutual funds get beat by the market. And yet, some don’t. There have been funds in the past decade and prior that have been very successful. For example, The Sequoia Fund, Peter Lynch’s Fidelity Magellan Fund, and the Vanguard funds, to name a few. What can you do to ensure your money will be safe when choosing a mutual fund to invest in? Look for the following indicators that could lead to high returns on your investments.

1. Their own managers are their biggest shareholders. These managers are much more likely to manage your funds as if it was their own, lowering the chances of the above downsides occuring. A fund’s proxy statement and Statement of Additional Information, both available from the SEC at the EDGAR database or www.sec.gov will disclose whether the managers own at least 1% of the fund’s shares.

2. They are cheap. The common misconception that higher mutual fund fees result in higher returns has been proven wrong with decades of research; in fact, funds with higher fees have actually shown to provide lower returns. Furthermore, while high returns from a fund may be temporary, high fees will stay despite the fund’s performance. You should look for a fund that either charges a low flat fee which will not eat away at profits, or perhaps even variable based on performance.

3. They are exclusive. It may sound a little counter-intuitive to invest in a fund that is practically closed to new investors, but it is possible. And not only is it possible, but it will help the fund keep its investments where they are successful, and avoid having the fund inflate the stock price with millions of dollars of additional buying power. Some funds that have solid records of not accepting new investors are Longlead, Numeric, Oakmark, T. Rowe Price, Vanguard and Wasatch.

Lastly, remember that past returns are not a good prediction of future earnings, mainly for the reasons offered above. Taken from chapter commentary by Jason Zweig, a popular business columnist, in the “Intelligent Investor”, the following table shows some examples of the point I was trying to get across this whole time:

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