Monday, November 26, 2012

Mutual Funds: Investors Beware

There was a time when an investor would purchase a share in a publicly traded company and assume that share’s price was a reasonable representation of its actual value. The investor could expect the value to increase or decrease as the business fortunes of the company increased or decreased as it used the funds from that share creation to further its interests. The situation today is much more complex. John C. Bogle provides insight into what the world of investing has become in his book The Clash of the Cultures: Investment vs. Speculation. Most investors enter the markets via mutual funds and pension plans. Mutual funds will be the principle topic here.

Investment has long been beset by agency issues. The rise of public corporations meant that an agent had to be hired to manage the enterprise. These agents could have agenda’s that were not in alignment with the best interests of the corporation and could use their positions to enhance their own wealth at the expense of the corporation and its investors. This agency problem was supposed to be controlled by holding directors responsible by means of tying compensation to performance. Influential economists created the notion that the best indicator of performance should be maximizing the wealth of the corporation. Given perfect markets, that wealth would be represented by the share price. Executives had marching orders to maximize the share price, and it was assumed that shareholders would keep them and their Boards of Directors honest. The use of potentially volatile share prices as a measure of wealth, and as a determinant of executive compensation, forced attention on meeting short-term market expectations. This could be accomplished by financial engineering if necessary, even if at the long-term expense of the company.

In the days when shares were mostly owned by individual investors, the assumption was that the investors were in for the long haul and expected the company to be focused on long-term growth and prosperity. The ability of these individuals to impact company policy was always minimal, but the rise of institutional investing created another agency issue. About 70% of corporate shares are now owned by institutional investors, mainly mutual funds and pension plans.

Bogle describes how the mutual fund industry evolved from one focused on investing for long-term gains, to one more interested in attaining short-term gains. He describes developments over the 60 years of his experience in the business:

"During that long span, fund assets increased by nearly 5,000-fold—from $2.5 billion to $12 trillion. A profession once focused largely on investing became a business largely focused on marketing. Of course such growth makes change inevitable. But the counterproductive form of change that developed was fostered by a sea-change in the industry’s culture, from private ownership to largely public ownership and the near pervasive control of fund managers by financial conglomerates. For fund shareholders it was a tragic change."

The new mutual fund environment also focused on short-term gains, and as principal "owners" of corporations, this view supported the short-term focus of company executives.

"Together, these two sets of agents came to an apparent, if tacit, understanding that the principle focus of corporate accomplishment is ‘creating shareholder value.’ That’s a fine goal, of course, but their shared definition of value focused on the short-term, evanescent, emotion-driven price of the stock, rather than the long-term, solid, reality-driven intrinsic value of the corporation."

Bogle refers to this conspiracy between corporate management and institutional investors as a "double agency" problem. Indeed, his description of the mutual fund industry as it exists today suggests that there is a third agency issue, one critical to fund investors.

"Today, among the 50 largest mutual fund complexes, 41 are publicly held, including 33 held by conglomerates. Only eight remain private....All of the public fund management companies have external owners, and thus a second master to serve."

If fund managers were compensated based on a metric dominated by fund performance, then a long-term approach to investment for consistent gains could be appropriate. But that is not the way the system works. Fund managers are paid according to how much money they control. A typical fee is about 1.5% annually on all funds under management; and that is independent of performance. The focus of managers then is to use fund performance as a marketing tool to attract more money. Fund performance is the bait for attracting more investors, but it drives the funds into a highly speculative mode in order to better the competition. This doesn’t, and can’t work in the long term, and investors suffer the consequences.

Fund managers require money to pay themselves lofty salaries, to cover the transaction costs involved in churning stocks in order to try to gain that extra advantage, and money to pay for the marketing required to attract more money. If publicly owned, the fund manager must also extract funds from its investor-clients to provide profit for its investor-owners. How about that for a conflict of interest?

As mentioned, fees have grown to average about 1.5%. A fund portfolio that actually increases in value by 5% annually, would deliver only 3.5% annually to the investor. The difference between 5% compounded annually and 3.5% compounded annually becomes enormous over the years.

To Bogle, the system is not only wasteful, but also shameful.

"But do these costs enhance returns to shareholders? It’s simply not possible. Since fund managers, in essence are the market, how could they—as a group—beat the market? (Or, for that matter, lose to it?) But when they are the market, the gross returns of investors must match those of the market, but net returns after fund expenses must inevitably fall short."

"Such enormous costs seriously undermine the odds in favor of success for citizens who are accumulating savings for retirement. Alas, the investor feeds at the bottom of the costly food chain of investing, paid only after all the agency costs of investing are deducted from the markets’ returns...."

Bogle is famous for having invented the index fund which tries to track an entire market or market segment, thus avoiding speculation and guaranteeing gains equal to the market. Such a construct has no justification for high fees and can be found in the range of 0.25% or less. As an exercise try compounding money at 4.75% rather than at 3.5% over an investment lifetime.

More on Bogle’s book and his investment advice can be found in Investing in Wall Street’s Casino: The House’s Take.

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