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Mutual Fund Mania

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I was amazed, then incredulous, and then finally resigned as I listened to a conversation on the radio this morning about mutual funds.

The commentator was talking to a professional investor in mutual funds, a manager that picks funds for his clients, about the sale of Strong Capital to Wells Fargo Bank. They were discussing the fact that the company sold for half of what it would have before it was found that hedge funds and the CEO himself were "bucket" trading the funds shares.

So far so good. But then the "expert" began discussing his strategy of how he invests in a portfolio of mutual funds in order to "diversify away manager risk" for his clients. In other words, by holding many mutual funds he can avoid large losses if one manager blows up for one reason or another.

This fact is true but it does not save his strategy from being disingenuous at best. An equity mutual fund like Strong Capital is an organization comprised of portfolio managers and back office staff with the objective of picking stocks to outperform the stock market. This out performance is called "alpha". On average mutual funds will charge around 1% to 2% of assets per year to do this.

I have commented in the past that the average mutual fund over the last thirty years has not accomplished this. Some do and some don't and people always try to "pick" the ones that they think will, but this is statistically very difficult.

But back to our expert and his strategy. He was claiming that his diversification of diversified mutual funds accomplishes much, but he wasn't discussing the fact that it also accomplishes something very undesirable.

Since each fund is attempting to obtain "alpha", the more funds he invests in, the more the alphas of each fund will tend to cancel each other out: investing in two mutual funds may (or may not) actually increase alpha, but investing in many will almost certainly decrease alpha.

So the more diversified he becomes among mutual funds, the more his portfolio will look like the stock market itself, which by definition has no alpha. So the expert could accomplish his same objective much more efficiently by just buying the stock market period. He can do this very easily by just buying SP500 futures or SPYs. There are other advantages as well, like taxes, by investing in SPYs versus mutual funds.

But if the expert did this, how could he justify to his clients the higher fees that he charges? He is essentially an index fund in disguise that charges probably twice the fees that an index fund charges.

The only thing he needs is investors that don't understand what is going on. And the only way they will figure it out is over years of underperformance.

This is a good example of how much of Wall-Street works. The mutual fund scandal showed all of us just how seriously fiduciary responsibility, doing what's best for the client, is taken by some if not many on Wall-Street.

That is obviously not serious enough, at least compared to the often diametrically opposed objective of making money for themselves.

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