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Phillips: Investors Buying Good Funds, Poorly

Don Phillips: The industry has improved, but problems remain.

Don Phillips, 04/07/2011

This article first appeared in the April/May 2011 issue of Morningstar Advisor magazine. Get your free subscription today! 

U.S. investors buy good funds, but they time their purchases and portfolio tilts so poorly that they squander much, if not all, of the benefits of buying quality funds. Before one gets too down on this assessment, however, it's worth noting that the situation today is far better than it was in the mid-1980s, when I started tracking funds. Then, investors bought bad funds badly. It's tough to overstate the improvement in the industry over the past quarter-century. Back then, many of the industry's biggest players were also its worst. The wirehouses dominated the industry, and firms like Dean Witter, Shearson, and E.F. Hutton touted gimmicky funds that charged high fees, stretched for yield, and routinely blew up on investors. Contractual plan funds that charged more than 50% of the first year's contributions in sales charges were still sold, even by reputable shops like Fidelity and AIM. The largest government-bond fund charged a 4% load to reinvest income distributions. A Kemper option-income fund manager ran a parallel account for the firm's executives and assigned winning trades to that account and losing ones to the public fund. In short, it was anything but a buyer's market.

Over time, however, media and analyst coverage of the industry grew. Many bad practices were rooted out. Advisors and other fiduciary-minded professionals directed assets to lower-cost and better-performing funds. As the industry became better illuminated and advisors better informed, the funds landscape became more of a meritocracy. The big brokerage houses lost their leadership position in fund management, and most exited the business. In their place, investor- focused firms such as Vanguard, T. Rowe Price, American Funds, and PIMCO--none of whom were among the 15 largest fund families in 1986--rose to prominence. The result: Today, most of the biggest funds, such as Growth Fund of America AGTHX, Vanguard 500 VFINX, and PIMCO Total Return PTTRX, are big because of merit, not distribution might.PAGEBREAK

This development may seem inevitable, but it hasn't been replicated in all fund markets. In much of Europe, banks still control distribution, and asset flows align more with marketing muscle than with fund quality. U.S. investors should be pleased with their system. Nowhere else do investors enjoy such high-quality fund choices, have so much transparency, have such strong regulatory protections, and pay so little.

But all is not sunshine for the U.S. fund industry. The persistent problem of investors mistiming their purchases remains. As Morningstar's work with investor returns has shown, collectively investors cut off 1 to 2 percentage points per year from their returns by piling into asset classes at their peaks and deserting them at their troughs. The dent this puts in returns is as or more significant than fund expenses, and it applies to all types of investing--active, passive, and alternative.

The good news on this front is that the industry is increasingly aware of the situation. The arms-dealer mentality that prevailed in the era of Internet funds--We just make the funds, what investors do with them isn't our responsibility--is giving way to a recognition that the investor's experience is everyone's responsibility. Asset managers are increasingly focused on making their offerings easier to hold, either by embracing fund of funds solutions like target-date funds or by trying to build in more downside protection in order to keep investors from fleeing at market lows.

One sign of improved behavior has been in fund advertising. Historically, fund ads have been the single best contrarian indicator available. Look back at financial periodicals from early 2000, and you'll see scores of high-growth, tech-heavy funds being touted. Fast-forward to the market bottom of January 2003, and you'll see money market and government-bond funds dominating fund ads. Today, despite the strength of bonds over the past decade and the 2009-10 rebound for stocks, you see few ads touting long-term bond-fund performance or short-term stock-fund performance. Again, that's not the case globally. In a London tube station in January, I saw an ad touting the better one-year returns for gold over bank deposits, urging investors to shift their savings accordingly.

The U.S. fund industry is not perfect, but it's pointed in the right direction. Standards are rising. Much rides on the industry's continued good behavior. Investors have chosen funds as their vehicle of choice for securing their financial future. It remains to be seen if the industry will fully rise to the challenge or if practices that led to the market-timing scandals of the past decade again corrupt. Investors must remain vigilant, demanding best practices and penalizing bad ones. Ultimately, the quality of the fund industry will be a function of what investors demand.

Don Phillips is a managing director of Morningstar, Inc.

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