Tuesday, April 28, 2009

Mutual Fundosaurus

The following financial market commentary was written by Matt Malick and Ben Atwater. Matt and Ben recently started their own firm, Atwater Malick LLC. Matt was a student of mine and has a really insightful take on what's happening in the market. Ben and Matt have developed a sound and unique investment philosophy for their clients. They regularly write market commentaries and I plan to post them here for interested followers.

For many years, stocks have been a common method of building financial wealth. When purchased at a fair price and sold at a full valuation, stocks can produce stellar returns. In fact, even after the recent equity bear market, the S&P 500 has returned 7.41% annually over the past 20 years ended March 31, 2009 with dividends reinvested in the index.

Because of strong potential returns, stocks have gained ever greater popularity over the years, and the financial services industry has responded by devising clever ways for the “average” investor to participate in the stock market. These include common trust funds, mutual funds, variable annuities, exchange traded funds (ETF’s) and hedge funds. Along the way, the industry created countless other financial products as well. Some have stood the test of time and others have not.

As the famous investor Barton Biggs reminded us in a November 11, 2008 Fortune article, “there is no asset class too much money can't spoil.” While he was referring to hedge funds, we think this adage also applies to mutual funds. The first mutual fund was organized in 1924 as a method of pooling investors’ assets together to purchase a diversified portfolio of individual stocks. Early mutual funds allowed “small” investors to own a diversified basket of equities at a time when it was not yet cost-effective for everyday folks to directly purchase and monitor individual stocks. In exchange for limited transparency and control, mutual fund clients gained diversification and professional oversight of their portfolios.

Over the years, there have been dramatic changes in both the mutual fund industry and the options available to individual investors. The charts below show the explosion of mutual funds and of mutual fund assets in the United States.

Source: 2008 Investment Company Institute Fact Book

While the mutual fund industry has grown exponentially, technology and the Internet have expanded the options available to individual investors. Through the advent of discount online brokerage sites, retail investors are now able to purchase individual stocks for modest commissions. And thanks to the free flow of information through the Internet, investors and independent investment advisors can more easily access vast amounts of pertinent data about publicly-traded companies, including all Securities and Exchange Commission regulatory filings. Therefore, the opportunity now exists for individual investors to directly own interests in the companies that mutual funds are frequently trading.

So why are mutual funds still so widely used? We think a clue lies in the flow of mutual fund assets. As you can see from the charts above, total assets invested in mutual funds at the end of 2007 were roughly $12 trillion. But according to data from the 2008 Investment Company Institute Fact Book, total sales of mutual funds throughout 2007 were $24 trillion – almost twice the level of assets. Now that is salesmanship.

You can partially attribute this to the natural ebb and flow of money in the economy. Fortunes are accumulated and spent, funds are redeemed to pay for financial goals, and new millionaires are made each day. But in our view, the vast majority of this phenomenon can be attributed to (1) the transactional incentives built into the financial services industry and (2) performance chasing.

As you know, mutual funds are the tool of choice for most financial salespeople. These funds often carry hefty expense ratios and sales loads and can therefore be highly profitable when the salesperson closes a deal. Unfortunately, the profitability of a transaction sometimes ranks higher on the priority list than simplicity, transparency, and prudent advice.

According to a study called the Quantitative Analysis of Investor Behavior by financial research firm Dalbar, from January 1, 1988 through December 31, 2007, the average equity fund investor earned an annualized return of only 4.5%, while the S&P 500 returned 11.8%. We think this is attributable to “performance chasing,” a common reason investors churn mutual funds. This occurs when an investor sells a poorly performing fund in favor of the hottest performing fund. Reversion to the mean and Murphy’s Law dictate that the purchase of this “best of breed” fund will happen at exactly the wrong time, right before the fund starts to underperform.

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