Mutual Funds: Where Fun Came to Die

Structured Notes
The perpetually perceptive Matt Levine recently had this to say about structured notes (structured notes being a security created by attaching derivative contracts to a bond).

“The [underlying value of the structured note] will be, like $97. The bank will sell you the note for $100. The bank makes $3. It’s a pretty good business for the bank. What are you doing, though? The answer can’t be ‘buying $97 for $100.’ The structured note tells a story, and you are buying that story.”

Continues Levine--

“Here I want to suggest that the fundamental yet paradoxical business of an investment bank is to spend $97 manufacturing a thing that it can sell to you $100 and that you value at $115.”

Bingo! Structured notes provide the hope that accompanies an attractive story. They are not to be scrutinized closely. The moment that a prospective buyer begins to consider what a note might have cost to create, rather than what it may eventually pay, is the moment when the transaction is lost. Mathematically (if the investment bank isn’t staffed by chimpanzees), a structured note is always worth less than its quoted price. But to its new owner, it feels like a bargain.

With Levine’s example, the investor appears to receive money for nothing by gaining if the S&P 500 rises, albeit at a slower rate than the index itself, but avoiding losses entirely if the stock market declines. The worst outcome, per the contract, is that after three years the note will return the original $100. Such a deal! The note may well appreciate, but if not, its principal is fully guaranteed.

As Levine suggests, that offer might well seem to be worth more than $100. (Although $115 may be pushing the point.) Recognizing that the note is not, in fact, underpriced requires returning to the numbers. They relate a different tale. The bank gains if stocks go up, because it retains some of those gains. It also gains if stocks go down, because it returns only the nominal investment, thereby retaining the time value of that money. Heads it wins, tails it wins.

(True, the math isn’t quite that simple. The note’s derivatives costs reduce the bank’s returns. Nonetheless, if the bank’s financial engineers have done their job, the note will profit under all stock-market conditions.)

Yesterday’s Mutual Funds
The mutual fund business once operated this way, by selling something for nothing. The general, although not necessarily voiced, idea was that investors shouldn’t pay much attention to funds’ prices (that is, their loads and expense ratios) because doing so missed the point: Mutual funds did what everyday investors could not. Whatever those investors paid for their funds, the result was better than what they could have managed on their own.

For example, “government plus” funds, launched in the 1980s, offered yields that were well above what investors could receive on their own, by buying Treasuries, while retaining the advantage that their securities were guaranteed by the U.S. government. Such a fund’s net asset value might have been $10, but its true value was above that--because ordinary citizens couldn’t otherwise obtain the fund’s combination of above-government payouts and full government protection.

A few years later, short-term multi-market income funds delivered yields that were higher than short-term bond rates, while holding portfolios that barely moved. You could think of such funds as cash equivalents--except that cash never paid like that! This solution came courtesy of a complex investment strategy, featuring European debt and derivatives contract, that couldn’t be replicated at home. Thus, the funds’ generally high costs were immaterial.

The simplest argument came from the top equity funds. If they charged 1.5% in annual expenses, but returned 1.5 percentage points above the S&P 500 even after their expenses were paid, then who were shareholders to complain? Sure, an investor could pay nothing for portfolio management by making her own decisions--and nothing would be the value that she would receive. You get what you pay for.

Today’s Funds (and ETFs)
These claims now seem antiquated. You probably do not recall what happened to government plus or short-term multi-market income funds, but since they no longer exist, you realize that their fates weren’t happy. (They were not.) You also know that stock funds that reliably and consistently beat the market indexes have become in short supply. Indeed, the same may be also be said for bond funds.

In brief, you don’t think like a structured-note buyer. You don’t believe that mutual funds--and their younger siblings, exchange-traded funds--will be worth more than one dollar’s worth of value for every dollar that you invest. It is instead somewhat less. For every dollar that a fund accepts, its sponsor will remove something, as compensation for its services. The game sums to zero.

Unlike structured notes, mutual funds and ETFs no longer purvey in hope. Rather, they package convenience. Which means that the analysis has changed. With rare exception, funds no longer market themselves on what they might accomplish. Their positioning instead concerns what they don’t do--the costs that they do not charge their shareholders, because they are cheaper than their would-be rivals. The conversation is about less, not more.

The industry’s excitement, it must be said, is largely gone. Few thrills come from finding the best discounters. For this change, several parties are blame: 1) The investment markets, for becoming more efficient, and thus harder for professional managers to outgain; 2) The media, for shining a bright light that illuminates, rather than a dim light that flatters; 3) Financial advisors, for ruthlessly cutting expensive funds from their menus; and 4) Vanguard, for not only leading the cost revolution, but for engendering skepticism, by questioning the benefits of active management.

Pleasing the Wallet, Not the Eye
This column is not a complaint--quite the reverse; the disappearance of high-concept, high-cost funds has been of great benefit to investors. What’s more, with the stock and bond markets becoming so efficient, the most-reliable way for fund companies to improve their wares has been to lower their expenses. From my perspective, the fund business has become a model industry. The contents match the tin; the prices are attractive; and the scandals are almost nonexistent.

But may I be permitted, just this once, to lament the industry’s aesthetic decline? Back in the day, the mutual fund business had heroes and villains. It had stories. It offered the promise of miracles. Today, the industry has… packagers. It is the place where fun went to die.

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.