Mutual Fund Buyers Beware

Al Jacobs

No discussion of securities here in the early years of this 21st century can ignore what has grown to be the most powerful and profitable marketing tool of the industry: the open-end investment company known as the mutual fund. Since formation of the first such company in the United States in 1924, acceptance by the public has become virtually universal.

Quite simply, a mutual fund controls a pool of money provided by its shareholders which it invests in a portfolio of securities selected by the fund’s managers. In recent years they’ve proliferated like mushrooms, with over 10,000 existing – vastly more than the number of companies found on the New York Stock Exchange. They exist in near-infinite varieties offering almost every conceivable mix of securities.

For the potential investor with both limited expertise and assets, this type of investment vehicle seems to meet two important criteria: astute selection of securities and advantageous portfolio diversification. Though in theory the mutual fund should meet the intended needs, theory and reality do not always coincide.

Before describing my fundamental concerns, let me acknowledge that many mutual funds are legitimately operated by competent management and that over the years investors have profited from such investments. Recognize, however, that these favorable results were not necessarily the result of skillful selection of unique securities by the fund managers, but rather the consequence of a period during which the major indices posted their greatest sustained rises in history. There’s no particular magic involved. These funds merely rise and fall with the general fortunes of the market.

For many, the mutual fund can be a reasonable way to participate in the ownership of securities. However, those who make this choice should do it knowledgeably. As a start, you should familiarize yourself with the details. You must recognize terms such as yield, distribution, load, volatility, alpha and beta coefficient.

You should understand the concepts of conversion privilege and net asset value, and distinguish between index, sectorand non-diversified funds. In short, you must do your homework.

Having completed the preliminaries, it’s time to get specific. In the first place, when merely comparing the acquisition of mutual funds against direct purchase of corporate stocks, the latter will provide the better return. The reason is obvious: The additional brokerage costs of the fund operation must be superimposed on the investment. However if diversification is paramount, you may have little choice. In that case you’ll seek a fund, but one where the charges are not excessive.

The one charge found in most cases is the management fee. This is a payment for continuing investment advice, usually no more than 1% of the total net assets, normally deducted annually and automatically.

To be certain, the lowest management fees – often a fraction of one percent – are those assessed by index funds, which are a collection of securities whose composition mimics a particular market index, such as the Dow Jones Industrials or the Standard & Poor’s 500. Inasmuch as investment analysis and decision-making is not required of the managers, there’s no justification for a substantial fee.

From this point, the type and amount of fees and charges become less predictable. In recent years a major distinction is made between “load” and “no-load” funds, with further categorization as to low-load, medium-load and full-load. These “loads” are commissions charged to the buyers which can run as high as 8½% of the purchase price. The conventional recommendation is to avoid load in preference to no-load fundsand this is often where the admonition stops. By rights this is where the advice should start.

Many no-load funds, although assessing no up-front sales charges, incorporate other equally objectionable fees. These include redemption fees, often known as back-end loads, which must be paid when the shares are sold. A variation on the redemption fee is a deferred charge when shares are redeemed within a certain number of years, known as a deferred load.

Another goodie approved in 1980 by the Securities and Exchange Commission is known as the 12b-1 plan. This permits a fund to confiscate up to 1¼% per year of the fund’s assets for marketing purposes. At this rate, a participant in such a no-load fund over ten years will contribute 12½% of the investment in such fees – this may not be a load in the technical sense, but the Greek mythological figure Atlas would recognize it for the load it most certainly is. You may add to the undesirable list those funds that debit portions of reinvested interest, dividends and capital gains, known as reinvestment loads.

Finally, there are other less than obvious ways some no-load funds separate client from asset. For each fund, you must scrutinize the fine print to know where the bodies are buried.

Another complexity concerns the total assets controlled by a particular fund and its relation to performance. The debate is straightforward. Those advocating the smaller funds believe that beyond a certain size – perhaps $500 million or so – a sort of “financial muscle-boundness” sets in, as the ease of moving into and out of stock-holding positions is lost. Conversely, the arguments which favor the mammoth funds contend they can afford the finest analysts and will profit accordingly. As expected, the performance statistics are inconclusive; there may be a bit of truth and error in both arguments.

My feeling is that a fund’s overall size is more a secondary consideration, which perhaps dictates the style of investment and choice of securities, rather than a performance predictor per se. You will have to do your analysis and make your own decisions on this one.

Pardon the paranoia, but my real discomfiture is with the evolution of an industry in which the placing of investors’ money seems to have become, at best, a secondary consideration. The fact that a substantial and growing percentage of the nation’s assets is now committed to funds fuels a part of the concern. The rapid growth in the numbers and varieties of funds being offered triggers more uneasiness. But it’s the synergistic effect of these facts that could result in unpredictable problems for the clients, for the economy and for the nation.

Let me run the risk of asking rhetorical questions. Who are the thousands of officers and directors of the funds? How are investors’ interests advanced with an average fund manager’s annual compensation in seven figures? What is the background and experience of the multitude of securities analysts being employed?

Who will benefit from the growing trend in fund mergersand in what fashion? Is the investor really well served by a fund that merely places its monies in proportion to a specifically designed index or another that simply acquires shares of other funds? And above all, who in God’s name is watching the store?

A concluding consideration: Never ignore the reality that the mutual fund entails the business of corporate stocks and bonds. It’s not an endeavor in which gratuitous offerings will be forthcoming. Expect no charitable inclinations from the people you must deal with. Never forget that human nature insures insider abuse, and in the field of corporate securities it occurs without end. Remember also, Murphy’s Law – which has become an established international principal – predicts that complexities lead to mishap. The more interdependent each element of an investment program, the greater the chance of failure. And above all, master the details. The failure to do so is the leading cause of things which go awry.

A final thought: What the future holds for the mutual fund industry is hard to say, though one thing is certain: The fortunes to be made, legally or otherwise, constitute an insidious attraction. Is it possibly becoming a self-propelled labyrinth, with few realistic controls, in the hands of the unknowns of the world? If so, the nation will surely experience a misfortune of momentous proportion.

Al Jacobs, a professional investor for nearly a half-century, issues weekly financial articles in which he shares his financial knowledge and experience. Al may be contacted at al@abjacobs.com.

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