Wrong Again: Mutual Fund Conspiracy Theories

Three Strikes Anything as big as the mutual fund business brings detractors. Rivals, hoping to make inroads, mutter darkly about the industry's undetected dangers. With mutual funds, creating such worries is easier than with most fields, because of funds' connection with Wall Street. People willingly believe that the Street wishes to cheat them and is clever enough to do so surreptitiously.

Here are three major claims against mutual funds, alleged over the past 25 years:

1) Junior portfolio managers (1990s)--Investment firms assign their least-experienced managers to their mutual funds, reserving their top talent for their institutional separate accounts.

2) Hidden costs (1990s, 2000s)--Don't be fooled by stock-fund expense ratios; because of trading costs, their true annual expenditures are usually north of 2%.

3) Market time bombs (ongoing)--In the 1990s,

As with any good conspiracy theory, these accusations appealed to the blend of fear and self-pity. Somebody else gets the top managers, while I get stuck with the losers? That figures; the little guy never catches a break. My fund looks cheap, but it's not? Wall Street always has an angle. Some giant fund will take down the market? Hurt again by something that somebody else did.

Such claims were difficult for an outsider to disprove. For example, if somebody who promoted managed-account services (which competed directly against mutual funds) stated that their seemingly higher expenses were actually lower than those of funds, who could say otherwise? The counterarguments mostly came from the fund industry itself--which meant, not unreasonably, they were often disregarded.

Acquitted on All Counts The charges were, however, without merit. To wit:

1) Junior portfolio managers--Investment firms don't care much about the source of their assets. Money under management is money under management. However, with the industry's retail business growing faster than its institutional segment, and mutual fund records being critical for attracting 401(k) customers, investment firms had some incentive to put their top talent on their retail mutual funds.

(The related argument that hedge funds indirectly damage mutual fund returns, by hiring away the industry's leading managers, carries somewhat more weight but is overstated.)

2) Hidden costs--This one was easy to refute, for somebody with access to a mutual fund database, an Excel spreadsheet at the ready, and time on his hands. On average, equity mutual funds trail their benchmarks by roughly the amount of their official expense ratios. In other words, their hidden trading costs are so hidden as to not exist.

(A slight exaggeration. Equity funds do indeed incur trading costs that are not included in their expense ratios. However, for most funds those costs are minor and are offset by equally minor gains from the portfolio manager's active decisions. So, overall, the average result is a wash.)

3) Market time bombs--This accusation is the purest instance of emotion overcoming reality. The financial markets certainly can be overwhelmed by sudden selling pressure. Indeed, most market crashes are at least partially triggered by an unusually large sales order. But rarely, if ever, from mutual funds. They move too slowly. A besieged mutual fund might lose 5% of its assets per month to redemption. That won't give it any problem selling its securities, assuming they are reasonably liquid.

Follow the Money Mutual fund conspiracy theories fail not because those who run investment firms are intrinsically honest, but instead for economic reasons. As is so often the case, the money trail leads to the explanation.

To start, the mutual fund industry doesn't need to levy hidden costs, because it fares so very well without doing so. As revenue-collection schemes go, you can't beat: 1) charging by percentages, rather than dollars; 2) displaying those percentages in reports and statements, as opposed to presenting customers with a bill; and 3) extracting those payments from the product itself, instead of requiring a check. That is the best path for getting paid the most to do the least.

For another, the industry is unusually well regulated--and publicly lit. Not only can any investor view the many required mutual fund filings (an opportunity that most investors bypass, of course) but so can any third-party organization. Such as Morningstar. Thus, there is a huge amount of secondary information about mutual funds to support the primary sources. It is harder for mutual fund organizations to play fast and loose with the rules than it is for companies in many (if not most) other sectors. Not impossible, to be sure, but difficult.

The combination of having the good fortune to participate in a particularly lucrative industry, while facing relatively high media scrutiny, encourages mutual fund companies to occupy the straight and narrow. Particularly the major organizations, which have accumulated enough money so that they have much to lose. For those companies, operating at a time wherein their annual new sales are dwarfed by their existing assets, the major rewards come from avoiding mistakes.

Dull, but Not Dullards This holds even truer today than it did a quarter-century back, because the industry now is substantially larger, its growth rate has shrunk, and the Internet has brightened the media's spotlight. Always staid by Wall Street standards, the mutual fund business has become even more so. This is bad news indeed for your author, whose best-read column ever carried the clickbait title of, "The Dark Side of Vanguard's Success: A Reader's Argument." But surely good news for investors.

John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.