Mutual Funds: Value Added or Value Destroyed?

A friend recently approached me because her employer was discontinuing one of its pension plans, and she wanted to know how her investments had performed and what she should do with her money.  I had no intentions of pitching her, but the more I described the pitfalls of mutual funds to her, we inadvertently discussed why the style we employ at Lakshmi, separate accounts, is more amenable to most investors’ goals.  A separate accounts strategy entails each client having their own account, owned by the client and managed by the investment advisor.

While professional investors understand the limitations of mutual fund investing, most individuals do not understand the nuances that make them, in my opinion, subpar investment vehicles.

Let’s first review the pros of mutual funds:

1)      Exposure to stocks and bonds

2)      Allocation and specific investments selected by professionals

The advantages of mutual funds mainly stem from the professional management of client’s funds.  Client assets are pooled into one large fund, and the manager allocates the assets to the stocks and bonds he sees fit.  However, the perceived advantage of pooling client funds actually hampers performance of these funds in the long run.

Cons of mutual funds:

1)      Large size limits investment choices
Since mutual funds, especially the ones allowed by corporate pension plans, tend to be very large, the stocks and bonds they are able to invest in are very limited.  For example, consider a $10 billion mutual fund.  If the fund manager wishes to take positions in 20 stocks, he must deploy $500 million in each stock.  For regulatory, liquidity, and control reasons, mutual funds do not want to own more than 10% of any one company.  This means that each company must have a market capitalization of $5 billion or greater.  Obviously there are a huge number of companies out there with great growth potential that have less than $5 billion in market capitalization.  This makes sense because all large companies were at one point in time small companies.  However, because of mutual funds’ size limitations, investors are completely cut off from these opportunities.

2)      Lack of agility or mobility in investments
Since mutual funds are heavily regulated investment pools, they may only take positions in stocks and bonds.  This means that mutual funds are completely disallowed from owning currencies, commodities, futures, and options, which comprise a huge portion of global investment activity.  Furthermore, while mutual funds technically have the ability to short stocks, only about 10% of mutual funds have this ability, and fewer than 2% ever actually exercise it.  This means that mutual funds depend on rising stock and bond prices for their performance.  Given the volatile times as of late, this is a dangerous dependence at best and pure folly at worst.

3)      The relative performance game: incentive for managers to maintain mediocre performance
Mutual fund managers’ worst nightmare is to underperform the S&P 500 Index, or whatever index they claim to be their benchmark.  This is because underperformance of the index is a sure-fire way to lose clients, and eventually, one’s job.  To guard against this, mutual fund managers prefer to own the stocks in the index they want to be tracked against.  This is because if they own the stocks in the index, they may not outperform it, but they will certainly not underperform it.  If they choose to take a large position in a stock not in the index, they have the chance of outperforming the index but also of significantly underperforming it.  Basically, the risk/reward ratio for them is not worth the chance of losing their job and stature in the industry, so almost all managers take the safe approach, which is to replicate the performance of the stock indices as closely as possible.
However, not only is underperformance of the indices a large problem in the mutual fund industry, it is actually inevitable.  Since mutual fund managers may only take long positions in stocks and bonds, they depend on a rising stock market for positive performance.  Most stocks tend to move together, so the performance of a large mutual fund will almost never be more than a few percentage points different than the major stock indices.  Add to that the incentive that managers have to not underperform the index, and it is easy to see why very few mutual fund managers ever beat the index, especially after adjusting for fees.

4)      Mutual fund fees can be exorbitant
A disturbing trend we have observed recently is the compounding of mutual fund fees.  In such a manner, clients are placed in mutual funds with exotic and seemingly goal-focused names.  One such fund is the “Vanguard Target Retirement 2045 Fund.”  To the average person, this would seem like a good idea, a fund that is constructed so as to target your eventual retirement in 2045.  But why does this matter at all?  Is the manager going to try to make more or less money based on your exact target year of retirement?
This fund displays one of the oldest and dirtiest tricks in the mutual fund business, which is a mutual fund whose only holdings are other mutual funds.  The fees charged on the 2045 Fund are .2%, a seemingly cost-efficient structure.  However, the only holdings of the 2045 Fund are four other Vanguard mutual funds, and each of these funds charges their own fees as well!  This type of fee compounding is endemic across the mutual fund industry.
While basic index mutual funds can avoid such problems, the more exotic the fund, the larger the fees they charge.  Chances are that a pan-Asia, ex-Japan mutual fund will charge in excess of 3% annually, and may even charge an upfront load, meaning a percentage of your funds being deposited will take a haircut right off the bat.  If you consider that this fund probably has no shot of beating the index it is tracking, there is very little reason to pay such high fees.

In summation, the only real benefit of mutual funds is their ability to expose the investor to asset classes like stocks and bonds.  However, with the advent of ETFs, mutual funds are obsolete for this purpose.  ETFs are essentially electronic mutual funds that track indices and replicate their performance very closely, but with no human manager calling the shots.  Because they have no human workforce managing the day-to-day operations, ETFs also charge far lower fees than mutual funds and have historically had closer tracking to the indices.  For a passive investor who simply wants exposure to equity and fixed-income markets, ETFs are a superior choice than mutual funds.

However, it is our firm belief that Lakshmi Capital’s strategy, separate accounts, provides the best of all worlds.  Utilizing a separate accounts strategy, Lakshmi clients can have their portfolios tailored to their individual risk preferences, liquidity needs, income necessities, and all other investment criteria.  Furthermore, Lakshmi trades futures, stocks, bonds, commodities, and options for its clients, both on the long and short side.  Lakshmi can also invest in any size company it wishes, depending on the size of the client’s portfolio, in order to take advantage of growth opportunities in small and mid-capitalization companies.

We believe that separate accounts put the interests of advisors and clients in alignment, and provide clients with the best opportunities for profitable investment.  As investors grow wary of mutual fund giants who add little to no value, it is our hope that investors consider separate accounts at Lakshmi Capital a more attractive solution.

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