John Bogle, founder and retired chairman of The Vanguard Group, observed during an August 21, 2012 live interview on CNBC, that 50% of the mutual funds would be gone within the next 15 years1. Burton G. Malkiel, PhD, author of A Random Walk Down Wall Street (now in its tenth edition)2, states that over two thirds of mutual funds underperform and that no mutual fund with more than $1 billion under management has outperformed over the last ten years.
Why do retail mutual funds underperform with such consistency?
The answer to this question is not an obscure mystery but instead has four straightforward, distinct, causal elements. These four elements are: higher costs, lower tax efficiency, non-performance based objectives, and loss of talent. We examine each of these in turn. But first, let us quickly review the structure of a mutual fund.
A mutual fund is a legal mechanism or structure by which a large number of unrelated and widely dispersed investors commingle their investment dollars within a single bucket. A portfolio manager is then hired to invest this single bucket of money across a diversified set of securities (such as stocks and/or bonds). When an investor places his dollars into the bucket (the mutual fund) he gets in return units in the fund (shares of the bucket). It is important to understand that he never actually owns the underlying securities. Mutual funds are governed by federal law and regulation, which severely constrains what the portfolio manager is allowed to invest in and how he must construct his portfolio. So what is it about this structure that causes mutual funds to so consistently underperform?
Higher Costs.Mutual funds have many of the same costs as any other investment portfolio. However, they have additional expenses in six specific areas. The legal and mechanical structure of a mutual fund requires them to have a fund accountant, fund administrator, fund auditor, and a fund board of directors. These are additional incremental costs not born by separate account managers. Nevertheless, these extra costs pale in comparison to the far more insidious cost burdens originating from two additional sources, i.e., trading costs and abusive hidden fees.
Recall, that when you invest in a mutual fund, you are commingling your investment dollars with thousands of other investors. Every single day, the mutual fund portfolio manager must absorb significant cash inflows and accommodate sizeable cash outflows. These significant daily cash flows force the portfolio manager to be continually trading the portfolio – thus generating surprisingly large performance destroying trading costs. It is not unusual for a mutual fund to experience a 4%, 5%, or 6% annual performance drag just from trading costs alone.
The various costs of running a mutual fund are charged directly to the fund itself. Investors in the fund are never sent a bill or otherwise notified directly about these costs. The semi-hidden nature of mutual fund expenses creates a powerful incentive for the mutual fund companies, who create and offer mutual funds, to charge excessive fees.
Lower Tax Efficiency. Because a mutual fund commingles the assets of thousands of investors, the portfolio manager is forced to trade the portfolio far more frequently in order to handle the resulting cash inflows and outflows. This forces the portfolio manager to realize capital gains far earlier then he otherwise would – delivering a far more tax inefficient solution. Unfortunately, the tax implications are even worse. The more frequent trading, resulting from the commingled structure, forces a larger portion of the capital gains to be realized as “short-term” as opposed to “long-term” than would otherwise be the case. This is a severe tax penalty when one considers the difference in tax rates between short- and long-term capital gains.
Non-performance Based Objectives. Mutual funds exist for one and only one reason, which is to make profits for the mutual fund company that creates and offers the funds. Their objective is to maximize their own profits as opposed to the profits of the individual investors in the fund. The consequences of this distinction are legion. A mutual fund maximizes profits for its sponsor by successfully maintaining four key attributes, i.e.:
- The capacity to grow very large,
- A high level of liquidity,
- An unusually attractive marketing story, and
- A performance level that never falls too far behind the pack.
The capacity to grow very large. Mutual funds make profits for their sponsors by growing as large as possible. This means that they must be structured for maximum capacity. Unfortunately, to maximize capacity, the portfolio manager over-diversifies, which by definition prevents him from ever outperforming. The greater his capacity, the more he must invest away from his best investment ideas – undermining performance.
A high level of liquidity. Large mutual funds must also maintain high levels of liquidity. This liquidity is required by law and regulation, but at a more practical level, it is necessary to handle the potentially gigantic inflows or outflows that could result from the thousands of individual investors all comingled together within a single bucket. The maintenance of higher liquidity forces the portfolio manager to forgo using some of his attractive investment ideas, i.e., those that just don’t have sufficient liquidity. This particular effect happens with surprising frequency. Worse yet, it requires the portfolio manager to maintain higher cash balances than he deems prudent and to underweight his best investment ideas.
An unusually attractive marketing story. A successful mutual fund, from the sponsor’s standpoint, is one that gathers assets quickly and in size. All too often, this depends on the sponsor offering a mutual fund with a trendy storyline. Today, we see this effect in two new areas, i.e., current income and alternatives. Frequently the such trendy portfolios are untried, untested, and take on a multitude of exotic risks – often at a point in time when the asset category has severely out-performed and is about to experience a painful downward correction.
A performance level that never falls too far behind the pack. Finally, mutual funds are able to attract and retain assets by delivering performance that is solidly within the pack. This is the devil-take-the-hindmost problem. The mutual fund benefits little from delivering genuine outperformance, but is severely penalized (with withdrawals) for running measurably behind the pack. The consequences of this phenomenon are severe. Mutual funds now have a strong incentive to just track their competitor’s performance instead of seeking actual out-performance. Tracking another’s performance is a relatively easy task – it only requires matching the competitor’s asset mix, something a monkey could do. As a consequence, mutual funds hug their benchmarks, over-diversify, and avoid over-weighting the portfolio manager’s best investment ideas. Each of these actions serves to prevent any chance of outperformance.
Loss Of Talent. The hedge fund industry continues to grow rapidly. To support this growth, it is gathering much of its new talent from the mutual fund industry. Those mutual fund portfolio managers who are most interested in actually delivering superior investment performance are migrating to the hedge fund industry. Hedge funds have been able to attract the best and the brightest – offering them significantly higher compensation. A surprisingly large brain-drain has resulted, sapping the strength of the mutual fund industry.
The inability of retail mutual funds to deliver outperformance explains their rapid and accelerating loss of market share. On one side, index funds, ETFs, and ETNs are pulling passive investment dollars away from mutual funds. On the other side, hedge funds and private equity partnerships are pulling active investment assets away from the mutual fund industry.
Mutual funds have responded by claiming that they can deliver the benefits of the most successful hedge fund strategies but within the protective wrapper of a SEC-registered vehicle, tightly governed by federal law and regulation. Unfortunately, they are once again engaged in weaving a spider web of fluffy marketing stories. This won’t end well – but that is another story.
Is there a solution? Yes. Technology and regulation have advanced to a point where each of these problems can be successfully mitigated through the use of separate account managers – a solution whereby an investor’s assets are not commingled with others. Certain asset categories cannot be delivered, or are poorly delivered, within separate account structures. However, for these more specialized asset classes, the industry has provided attractive Exchanged Traded Funds, Exchange Traded Notes, Unit Trusts, and Closed End products.
The days of mutual fund wrap are numbered.