Focus of Mutual Funds Turns to costs

[runningman]

From the WSJ:

Thanks to the price cuts, Fidelity's index funds are cheaper than the comparable offerings from archrival Vanguard Group. Expenses for Vanguard's "investor" shares range from 0.18% for its S&P 500 fund to 0.29% for its international-index fund.

Yet, even with those higher expenses, Vanguard's index funds have outpaced most of the competing Fidelity funds over the past six months. What happened? A Fidelity spokesman says that, in two instances, the performance gap reflects Fidelity's decision to adopt the latest version of the underlying index, which hasn't performed as well as the old version during the past six months.

But William Bernstein, author of "Four Pillars of Investing," credits the skillful trading of George Sauter, who has run Vanguard's index funds since 1987. "Transactional skills are every bit as important as simple expenses," Mr. Bernstein argues.

and

In 2003, about 70% of the money flowing into stock funds went into funds with an expense ratio of 1% or less," notes Brian Reid, chief economist at the Investment Company Institute, the Washington trade group. "People tend to gravitate toward funds with lower fees."

http://makeashorterlink.com/?J2E9422AA

[runningman]

Article on Vanguard vs. Fido's price cuts and Clements' article:

The implicatons of the index funds price war

http://www.seekingalpha.com/2005/03/the_implicatons.html

[Bylo Selhi]

The point that's being ignored is that Vanguard is more trustworthy than Fido or E*Trade. Sure, the pretenders can offer lower cost funds as loss leaders. They can also claim the lower costs are permanent. But what happens when they can no longer afford to eat the losses?

Vanguard, on the other hand, has staked its reputation on low-cost indexing. Unlike the pretenders, they can (and do) break even, even at these levels. Indeed, when they announced the International VIPERs last week they also announced the reduction of several US ETFs down to Fido levels and below (e.g. 7bp for VTI.) Clearly Vanguard's record since 1976 shows their commitment to increasingly lower costs, both for actively-managed and index funds. Neither Fido nor E*Trade can claim that.

One shouldn't underestimate the importance of this trust/faith that some of us have in Vanguard. Investing, especially indexing, is a long term endeavour. If their fundco raises MERs some years into the future it may not be possible for an investor to switch to a lower cost competitor because of the substantial capital gains tax liability that has accrued. Investors should ask themselves if they can trust their fundco to keep costs at a minimum, not this year or next, but over the next several decades.

The author can criticize Dr B, but he can't refute the fact that he's pointed out repeated, both via Clements and via his own website, that Vanguard's Gus Sauter executes better than his peers. Even before the MER price war Gus was able to add enough value to more than offset the MERs of several index funds. Now that challenge will be even easier for him to meet.

[runningman]

I agree with everything you're saying Bylo. I just thought it interesting to post an article that was critical/contrary to Clements' stance. I respect and admire Clements and Bernstein immensely.

I trust Vanguard enough to invest my own $$ in it.

[George$]

David Swensen really takes on the mutual fund idustry in today's Wall Street Journal.

Here is some text from the interview

Monthly Mutual Funds Review --- Yale Manager Blasts Industry --- His Advice to Individuals: Choose Index Funds, ETFs Over Active Managers

By Tom Lauricella
2,105 words
6 September 2005
The Wall Street Journal
R1
English
(Copyright (c) 2005, Dow Jones & Company, Inc.)

Among individual investors, David Swensen isn't a household name. But he is an icon in the world of big institutional money managers such as endowments and pension funds.

Mr. Swensen's fame comes from his oversight of Yale University's $15 billion endowment fund, which, since he was hired 20 years ago, has returned an average of 16% a year, far outpacing the market and other funds run for universities. Before arriving, Mr. Swensen had never overseen an institutional portfolio, and he brought to the job an unconventional approach for dividing up the portfolio among different asset classes. He is now Yale's chief investment officer.

Five years ago, Mr. Swensen set out to write a book that would bring the lessons he learned to individual investors. Instead, he says he found that the option most accessible to individuals -- mutual funds -- often makes it impossible to beat the market. And even when they do find good managers, individuals end up shooting themselves in the foot, he says.

So while Yale relies on actively managed portfolios, Mr. Swensen says individuals should just stick to index funds, especially those run by not-for-profit companies. He also likes exchange-traded funds, which trade on exchanges like stocks, but says "buyer beware."

Excerpts from an interview with Mr. Swensen follow:

WSJ: You had hoped to give small investors a road map for beating the market based on Yale's approach to investing. What happened?

Mr. Swensen: I found when I started down that path that individuals just don't have the same set of investment opportunities available to them that we do here at Yale. In fact, the evidence showed me that the mutual-fund industry has completely failed to provide reasonable active-management returns to individuals.

WSJ: To say that it completely failed -- that's a pretty harsh statement to make.

Mr. Swensen: I think the evidence is there. The crux of the failure is with the for-profit management of funds for individuals. Mutual-fund managers have a fiduciary responsibility to investors. Obviously, if they are operating in a for-profit mode, they have a profit motive. When you put the profit motive up against fiduciary responsibility, that fiduciary responsibility loses and profits win.

WSJ: But the investment managers that Yale hires -- or any other institutional investor hires -- are out to make money.

Mr. Swensen: But there it's a fair fight. In the context of Yale, you've got a sophisticated institutional investor on the one hand and a for-profit provider of investment services on the other hand. And we can go toe-to-toe and end up with a fair result. If you look at Yale's history over the last 20 years, we have excellent results in terms of active-management returns.

The problem in the mutual-fund industry is that you've got a sophisticated provider of investment services on the one hand and, on the other, you have an unsophisticated consumer. That imbalance leads to behaviors that line the pockets of mutual-fund managers and at the expense of the individual investor.

WSJ: What is some of the evidence that you believe shows that mutual funds have failed small investors?

Mr. Swensen: The data I cite in the book was put together and analyzed by Rob Arnott (chairman of manager Research Affiliates LLC). He adjusts for survivorship bias, an incredibly important phenomenon. If you don't do that, you are going to get a false picture of what the world looks like.

WSJ: So if you look at the regular data on fund performance, you're not seeing the whole story?

Mr. Swensen: You're not seeing the losers that disappear. They could disappear because they go out of business or because cynical managers of mutual funds will take poorly performing funds and merge them into better-performing funds, and so the record of the poor performer disappears. The picture that you get if you just look at the survivors is dominated by the winners -- but of course investor dollars were invested with the losers that disappeared.

And if you look at the aggregate results of the mutual-fund industry on an after-fee, after-tax basis and adjust it for survivorship bias, the probability that you are going to end up with market-beating returns is de minimus. According to (Mr. Arnott's data), the 10-year after-tax shortfall for mutual funds is 4.5% per year relative to what you would have gotten if you had put your money in an index fund.

That doesn't even take into account the fees for advice . . . which takes you from a de minimus probability to a virtual certainty that you will end up losing relative to the market.

WSJ: What keeps funds from living up to their promise?

Mr. Swensen: So many of the behaviors that lead to high-quality investment performance diminish (managers') profits. For example, size is the enemy of performance. If you limit assets under management, you have a much better chance of beating the market. But asset gathering improves profits. So what happens? Almost invariably, managers are out there gathering assets, trying to increase profits, and it comes at the expense of generating investment returns.

Concentration is another important factor in generating high levels of incremental returns. We have managers in Yale's portfolio that will hold three or four or five stocks, or maybe eight or 10 stocks. You have to have an enormous amount of conviction, and you have to really believe that you have got an edge to make those kinds of concentrated bets. But it's not sensible for a mutual fund to do that from a business perspective because the volatility of the results relative to the market will be way too great, and the manager of the mutual fund will likely not be able to amass the same level of assets they would if they pursued a much more diversified strategy.

It also doesn't scale. If you are trying to run a concentrated portfolio and have a huge amount of assets under management, you just can't do it. One of the best managers out there has had as few as three securities and never more than 10. If you're Fidelity Magellan, with $50 billion or $60 billion, there's no way you can just put three stocks in the portfolio.

As we're going down the laundry list of reasons why mutual funds fail, you have to talk about the turnover in the portfolios. A very significant portion of assets in mutual funds are taxable, and the overwhelming majority of mutual-fund assets appear to be managed with complete indifference to the tax consequences. It's probably not criminal, but it should be.

There is more but for copyright reasons I did not think I should quote in full.

[Norbert Schlenker]

Of course, this is only in the US.

... According to Freeman, in the next year you can expect to see more than two dozen cases going to trial in federal courts all over America, against Fidelity, Federated, Franklin-Templeton, MFS, AIM and others. This is significant because they're based on a totally new legal strategy: For two decades excessive-fee cases never got to trial. Industry lawyers routinely got them dismissed based on the Gartenberg vs. Merrill Lynch ruling that essentially said if a fund's expenses were in line with the expenses of similar funds, the fees could not be excessive (no matter how high!).

But now federal judges are letting these new cases go to trial based on a new theory: Plaintiffs argue that the fund industry's explosive growth has generated economies of scale that fund managers are not sharing with all investors. Instead, the benefits are shared primarily with larger investors, or favored institutional clients, or simply pocketed by insiders, all of which is a violation of the fiduciary duties imposed by the 1940 act. ...

Farrell, Marketwatch (perhaps reg required?)

[Bylo Selhi]

Instead, the benefits are shared primarily with larger investors, or favored institutional clients, or simply pocketed by insiders, all of which is a violation of the fiduciary duties imposed by the 1940 act.

Ouch! That could easily bite even Vanguard, who offer lower ERs to retail clients with holdings of at least $100k per fund (Admiral class shares), despite their long and relentless obsession with passing economies of scale to all clients.

(perhaps reg required?)

If anyone has a problem, could they please try this link, courtesy of Google, and let me know. Failing that, there's always http://www.bugmenot.com/ (and for Firefox users this extension.)

[Bylo Selhi]

Of course, this is only in the US.

Yabbut, this angle isn't

Leaving clients' money on the table

Leaving clients' money on the table
Fund managers risk lawsuits by failing to claim

Edward J. Waitzer, Financial Post, Wednesday, September 21, 2005

Fund managers who have quietly registered their disapproval of shareholder lawsuits by choosing not to participate in recoveries from securities class actions have long been exposed to investor complaints. They in turn have often shifted the blame to custodians for not informing them about, or assisting them with, such suits.

Both should be very careful in future about leaving other people's money on the table because complaints may soon turn into class-action lawsuits alleging breach of fiduciary duty.

Make no mistake, the stakes are substantial. In 2004, the total value of all securities class-action settlements in the United States was US$5.5-billion, compared with US$1.9-billion in 2001. Just in the first quarter of this year, over US$4-billion was recovered.

Twenty-nine foreign issuers were sued in private securities class actions in the United States in 2001 -- the highest number ever. But for the first time it's roughly in proportion to the percentage of foreign registrants listed on U.S. exchanges, about 14%. So there's no reason to think that is about to change.

Because of the size of their equity holdings, institutional investors tend to be able to recoup significant amounts for their clients by simply filing a claim.

Yet an upcoming Law Review article suggests they are failing to do so. The authors found about 70% of fund managers with significant provable losses fail to even submit claims in settled securities class actions.

The result is a greater recovery for those who take part in the process because the settlement pool is distributed to them. But it may be problematic for the people whose money was actually lost.

A second troubling aspect of the survey is the way in which settlement payments received by institutional investors are allocated.

Ideally, the money should be credited to those investors who held interests in particular funds at the time of the loss suffered in proportion to their share of the losses. But rather than wrestle with the complex record-keeping and administrative calculations that would entail, most fund managers who file claims either deposit the recovered money into the portfolio that suffered the loss or credit the recovered funds generally for the benefit of all current investors...