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The No in Innovation

The vast majority of mutual fund innovations have led to bad investor experiences.

Don Phillips, 07/30/2009

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At the recent Morningstar Investment Conference, Vanguard founder Jack Bogle expressed his admiration for a Shredded Wheat marketing slogan that claimed the cereal put the "no" in innovation. It's easy to see why the tagline would appeal to a longtime student of the fund industry like Bogle. Simply put, the vast majority of mutual fund innovations have led to bad investor experiences. Far too often, fund innovations increase complexity, drive up costs, and tempt investors to take on added risk at market peaks or to retreat to apparent safety at market lows.

Still, innovation is a constant temptation--Bogle himself launched dozens of funds during his time at the helm of Vanguard--and some innovations do work well. Money-market funds, for example, were a valuable innovation, as were index funds. Even funds focusing on small-cap stocks were once an innovation. So, how is an investor to distinguish between the beneficial and the dangerous? Clearly, biting on every new idea would be foolish, but so, too, might be rejecting new approaches. Investors and fund companies should ask if the potential benefits of a new approach are offset by 1) greater complexity, 2) higher costs, and 3) a heightened potential for misuse.

Increased complexity is at the heart of many, if not most, of the financial industry's worst debacles, including the current crisis. Sadly, the fund industry has often been a party to this trend. Just consider the industry's long line of overengineered new ideas, ranging from option income, to government plus, to short-term multimarket, to 130/30 funds. Each was a complex strategy that was untested in the mutual fund format and was aggressively touted as offering either enhanced returns or yields. Unfortunately, each strategy produced generally disappointing results, soiling the reputations of the firms that promoted them and hampering the returns of those investors who chose them. Today's absolute-return funds strike many objective observers as following in the same sad steps of these overpromised, overengineered ideas.

Increased complexity does have one big advantage for asset managers: It provides a justification for higher fees. Almost every new concept in the fund world, with the notable exception of broad market index funds, has involved higher costs. One large fund company recently touted a fancy system for controlling risk in its new fund offering to us. Its portfolio strategist proudly explained that back tests had shown that the methodology could add up to 100 basis points of alpha per year. Under questioning from our analysts, however, he sheepishly conceded that the fund's 1.5% annual expense ratio would eat up all of this potential benefit and then some. (He defended the fee by noting that it's less than a hedge fund would charge.) It's one thing to be overcharged for a known service; it's something else entirely to be charged a fat fee for a theory.

Perhaps the biggest problem with fund innovations, however, is that they are generally brought to market at the worst possible times. Recall the fund industry's mad scramble to launch Internet funds as the tech bubble peaked. Playing to investor greed was an easy way to get sales in that overheated market, but it proved a poor strategy for building long-term client relationships or establishing a reputation for stewardship. In retrospect, it would have been brilliant to try to lock in a stable single-digit return in 1999 when valuations were at historical highs. But no firm touted Treasury funds in 1999, just as no firm aggressively pushed its stock or tech funds in early 2009. Too many fund companies exploit investors' fear and greed. A history of fund launches or fund advertising presents a painfully accurate contrarian indicator of what savvy investors should do with their money. Twenty years from now, will investors who pay big fees and front-end loads for an absolute-return fund that promises a 3% return look back favorably on that decision?

Trendy fund launches also tend to come from second- or third-tier players. Firms that have succeeded in established strategies (think American Funds, Longleaf, or T. Rowe Price) have little incentive to launch new types of funds. Rather, it is startup firms, those that have stumbled and are looking to rebound, or those that have been recently purchased, where management feels pressure to get rich quickly, where one sees firms trying to redefine the game so that they can join the industry's elite. Therefore, buying the latest hot fund concept generally means that you're not dealing with the industry's elite--hardly the soundest strategy.

One final caveat: The payoff for a successful fund innovation flows mostly to the fund family, but the penalty for a flawed innovation is paid largely by the guinea-pig investors and advisors who test the new idea and get burned. This asymmetric risk/reward ratio is reason enough for savvy advisors to share Bogle's skepticism. Before you bite on the latest hot fund, ask whose pockets are most likely to be lined, your clients' or those of the asset manager?

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