The Case against Managed Mutual Funds

Mutual Fund companies caught with their hands in the cookie jar? A recent article in the Journal of Indexes (July/August 2007, Hidden Fees Exposed!) cautioned that Mutual Funds were thought to be charging “Hidden Fees”. The article goes on to explain the various types of fees that are frequently hidden. These fees are typically identified as various and sundry “fund agency costs”, they are often obscured in a funds prospectus making them very hard to decipher. Thus the term “hidden”. Say it ain’t so, the average Joe investor takes it on the chin once again.

Agency fees, being the hidden nefarious pests that they are can often be difficult to quantify. However, it seems one ingenious professor has found a way to shed at least a sliver of light on this mystery. The Journal of Indexes article goes on to explain, “a group of professors led by Professor Rob Bauer figured a neat way to make an implicit measurement of their impact. Bauer et al, pulled together a study comparing the performance of mutual funds and traditional pension plans. Bauer’s team found that mutual funds underperformed pension plans by a whopping 150 to 250 basis points (1.50% to 2.50%) per year.” The study also found that Index funds lagged the pension plans by only 30 basis points. Additionally, it found “that direct costs only accounted for a slight difference in performance. They also believe that no real difference could be attributed to skill, because the funds and plans often had similar exposures, and in many cases identical managers. That left just one explanation for the lower fund returns- hidden fees.”

Why would pension plans out perform managed mutual funds, and index funds? Well come to find out, size really does matter, fortunately pension funds quite frequently are large, their size creates pricing leverage which allows them to better negotiate investment terms with brokerages and other client services. No, you can’t run out and create your own pension fund! But you can do the next best thing, utilize Index funds or Exchange Traded Funds (ETF’s), both of which have noticeably lower fees than managed funds.

For the uninitiated, Index funds are investment instruments developed to match a tracking index such as: the S&P 500 Index, the Dow Jones Wilshire 5000 Index, and the Russell 2000 Index. An Index fund will hold roughly the same company’s in it’s fund as that of the index. Some of the more common Index funds are the:Fidelity Nasdaq Composite Index Fund, Fidelity Spartan Extended Market Index Fund, Vanguard 500 Index Inv, Vanguard Small Cap Index Inv, and the Vanguard Total Stock Market Index Inv. Index Funds typically have very low expenses, a check of the Vanguard Total Stock Market Index (VTSMX) at on (18July2007) found the expense ratio listed as .19%, that’s below rock bottom.

Is there any wonder Warren Buffet wrote in his annual report from 1996, “Most investors, both institutional and individual, will find that the best way to own common stocks is through and index fund that charges minimal fees. Those following this path are sure to beat the net results delivered by the great majority of investment professionals.” In my not so lofty opinion, when a world class investor like Mr. Buffett takes time to advise individual investors they should sit up in their seats and listen.

Lets see what the much ballyhooed market madman Jim Cramer says about Index funds. In his book (Jim Cramer’s Real Money, Ch 7, pg 185) he writes, “As I’ve said elsewhere, I am a rank conservative when it comes to retirement: I want the money as diversified as possible into high-quality equities as defined by an index fund or a mutual fund that acts as an index fund with a brain.” So as to not take these remarks out of context Mr. Cramer is specifically addressing retirement accounts which he refers to as “too sacrosanct to play with”.

There are reasons seasoned professional investors such as Warren Buffett and Jim Cramer would have you investing in index funds. Managed mutual funds carry a level of risk that index funds simply do not have. That is, the chance that the manager of the fund will make a mistake in how they configure the fund with assets in conjunction with the market environment. Markets are inherently volatile, even index funds carry risk that is levered to the whims of the market, political events, natural disasters etc. The added risk that funds would impose “hidden fees” is just one more factor that increases the risk on return to the average investor.

Please don’t conclude that I am leveling the charge that all funds have hidden fees, that simply isn’t true. However, identifying fees that are plainly stated on the most readable fund prospectus’ can be a challenge to many investors, finding fees that are hidden could be an exercise in futility. Often in the realm of investing, minimizing risk is the individual investors only safe harbor. Index funds through good markets and bad will carry only the risk inherent to the market and it’s whimsy.