Screw this. The conventional mutual fund model is broken.

It pains me to say that.  I used to work for Rainier Investment Management, a good company with smart managers that ran (and still run) several relatively successful mutual funds.  They treated me well; I still have friends there, and I hope they prosper as a firm and as individuals.  I learned so much there–and ironically, learned why conventional mutual funds are a broken model.  At the time (mid-1990s), they were not.  Now they are as outdated as the idea of scanning a newspaper for stock prices, phoning a broker to get a current quote, and paying him 7% to buy a stock.

But at this point, I can’t recommend anyone invest money in conventional mutual funds unless there is no adequate alternative (as in most 401ks).  They have three big problems:  the creation/destruction of shares, the way they are transacted, and the fee locusts that eat away the money.  And that’s the no-load funds.  If there is a load (a massive commission paid to the manager for the privilege of becoming his or her customer), add a fourth big problem.  If your broker charges a transaction fee of any size, add a fifth.

Before we get into that, for benefit of anyone who’s not sure, let’s detail how a conventional mutual fund works.  I was present for the founding of four of them, so I understand how this happens.  A money management firm files all the necessary paperwork to open a mutual fund, gets assigned a 5-letter ticker ending in X, invests some seed capital, hires an agenting bank to custody the money/shares, and writes up a prospectus.  Included in this are the investment guidelines, which are what keep the manager from just buying whatever the hell s/he wants.  Typical guidelines sound like:  the Fund will invest no less than 80% of its assets in U.S. equities (that would be stocks)  with capitalization levels below $1 billion (that would be small cap stocks, i.e., little companies).  The fund may hold up to 10% of its assets in cash equivalents (that would be money market mutual funds, essentially the savings accounts of the investing world) at the manager’s discretion. Okay, fine.

All well and good…so you go to buy it.  You place an order (in dollars, not shares) during the market day.  A couple hours after market close, the fund reports its Net Asset Value (that’s the price per share) for that day, and your purchase executes, with amount of shares calculated to three decimal places.  Those shares were created on the fly, just for you.  Had you redeemed (sold), shares would have been destroyed.  Tomorrow morning at 6:30 AM PT (9:30 AM ET), your manager will start thinking about how to invest the new money you sent him (so to speak).  You’ll share in the fund’s gains, losses and fees.  What’s wrong with fees? Everyone’s got to make a little money, right?

Let us say that everyone’s got to earn a little money.  It is stupid to pay someone a fee to underperform (do worse than) the overall market, the performance of which can be purchased using an index fund.  The idea of hiring a pro, right, is that s/he knows stuff you do not, does major research, digs deep, knows the right questions to ask, has a finger on the market pulse? Then how come a majority of them do worse than the market indices they compare to, a majority of the time? With all respect to the pro’s hard work, what the hell benefit is the investor getting?

It makes sense here to explain the alternative, the index fund.  It may be conventional (which suffers from all the flaws of all conventional mutual funds, but suffers them with lower fees) or exchange-traded (hereafter called an ETF, mechanics different from conventional funds, explained later).  Its basic idea is that the manager just buys the securities in a given index.  Doesn’t take much brains, as the manager has zero discretion.  S/he must maintain the fund in as perfect a mirror of the given index as possible.  If you own the fund, your performance will be the performance of that index less relatively small, more reasonable fees than actively managed funds.

The only reason to pick conventional funds over index funds is the belief that the manager will beat the market on a consistent basis.  Most do not.  Most get beat by the market, accentuated by the fees.  This adds value…how?

In fact, it subtracts value–and you pay for that service.  Well, if I want to do worse than the market, I don’t need professional help for that.  If I want my investments screwed up, I’m capable of that all by myself.  Now that I’ve explained the model and how it functions, let’s detail why it is broken.

1) Creation/destruction of shares.  Sounds simple enough, right? Not so much.  Suppose the market is going great guns.  Everything the manager bought is fairly expensive right now.  Because the market is going great guns, investors’ money pours in.  The manager’s guidelines require him or her to buy–but there’s nothing out there that’s a good deal.  S/he must buy at the inflated prices.  Okay, now the market is eating flaming death, or the fund had a bad quarter.  Investors head for the exits.  They must be paid, meaning the manager must raise cash for redemptions.  But there’s nothing s/he really wants to sell right now! There is no choice.  The manager must sell a security s/he did not want to unload, probably because this is a terrible time to sell, locking in a large loss.  Both of those dynamics damage performance.  It’s bad enough with stocks; it’s worse with bonds, which is why conventional bond funds are such a dumb investment.  Bonds are mostly not traded on markets, but are sold from broker inventories.  One can’t just buy a bond index, as the bonds in it are not always available.  This is why bond funds can go up and down in price:  after their issue, bonds will trade at premiums or discounts to their original par.  So for a bond fund, you get the potential for losing money of a stock fund, but you don’t get the high upside of stocks.  Seriously? Who wants this?

2) The way they are transacted.  If you buy a stock or bond, you buy at a market price.  You can issue trading instructions.  If your trade conditions are met, bang, you bought it–same is true for selling.  If you buy a conventional mutual fund, you issue the order when the market is open, and after it closes, you find out the price you paid.  In what world is this even remotely acceptable? I have some books for sale.  If you place an order during the business day, I’ll fill it this evening, but I don’t yet know the price you’ll pay.  I’ll know that later.  Would you buy books that way? Then why will you buy thousands of dollars worth of mutual funds this way? Do you hate your money and want rid of it? If so, send it to me.  I won’t charge you any fees and I will pay your postage and/or wire fees with a friendly smile.

3) The fee locusts that eat your money.  The fees are not inconsequential.  How it works:  the fund pays out money, including (most significantly) to the manager for his or her professional expertise.  Okay, fine.  Typical management fees for actively managed stock funds amount to about 1-3% of the total money in the fund.  You pay that, though you do not see it occur.  Worse:  you pay that even when the manager underperforms the market.  Dead serious.  You often pay them to lose you money.  Is there a one of us who cannot lose his own money without help, for free? If you want a free money-losing service, the offer above stands.  I’ll take it off your hands and I swear not only never to charge you a fee, but to cover all costs.  Hang on; there are also 12b-1 fees, ranging from 0.25% to 1%, that go to pay people for marketing the fund.  I’m pretty sure, for example, that’s how Fidelity gets paid for its no-transaction-fee funds.  These, too, you pay whether the fund wins or loses.  How does it add value to you? It doesn’t.  It’s just a way to get you to pay the freight for marketing and distribution of someone else’s goods.  You are the customer, not the manufacturer.  Why are you paying your vendor to market his product to you? Isn’t that rightly his expense?

4) Sales loads.  Typically 5.75%, a one-time fee assessed when one buys (front-end load) or sells (back-end load).  Often called a ‘sales charge.’  The very term is insulting to one’s intellect and commercial sense.  You have to pay them a massive fee for the privilege of having them charge you further hefty fees to underperform the market? In order to make up for the crater this fee will put in your returns, the manager must outperform for years at a time.  Odds are heavily against that.  So, let me get this straight.  You’re willing to buy something this disadvantageous? I have a better idea.  Buy an index fund, and send me any portion of the 5.75% you feel fair and right.  I will cover all fees and expenses for this process, and I’ll never charge you any further fees for it.  Why do load funds even exist? That’s so that full-commission brokers, who sell the illusion that they are acting in their clients’ best interests and who get paid every time they trade securities, can get paid to put the client in mutual funds (which will not generate ongoing commissions for the broker, being typically buy-and-hold investments).  Full-commission brokers are as obsolete as sales loads, conventional mutual funds and learning the stock results from a newspaper.

5) Broker transaction fees.  These vary from discount brokerage to discount brokerage, so let’s talk about how Fidelity does it.  At Fidelity, I pay $7.95 to trade stocks up to some large amount of shares.  Some conventional mutual funds have no transaction fees (I assume because the fund managers agreed to slip Fidelity some 12b-1 fees).  Here is an excellent article about this.  Others have a $75 transaction fee.  If I buy $7500 worth of stock, I pay about 0.1% in commission.  If I buy $7500 worth of mutual fund shares, I pay 1% in commission (let’s call this what it is, shall we?). Every nickel of commission that you pay is a loss to you.  One always pays something, but in the gods’ names, why pay more for no benefit? Ah, but say you really want into that fund.  Do you want it badly enough to lose this much money immediately, so that a professional manager can then pay him or herself a handsome annual fee to do a worse job than an index fund? Because on balance, that is what is going to occur.

Think of your finances as a human body.  The conventional mutual fund model is a series of leeches, slowly but surely drinking the body’s nutrients.  In return for what? On balance, on average, in return for lowering the body’s health. What is the benefit? A sexy name? An illusion of security? Sorry, but to me it just looks like being covered with leeches.

If a single person asks, I will author a follow-up article about why ETFs and CEFs (closed-end funds) are so far superior.

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