Two Critical Problems with Conventional Mutual Funds

By October 24, 2016Investing

The Wall Street Journal did a whole series of articles last week on the big shift major mutual fund companies are seeing away from active management. See: Wall Street’s ‘Do-Nothing’ Investing Revolution. The evidence against active management has been around for quite awhile, but the outflows and public sentiment has really picked up recently, taking many of the large Wall Street firms by surprise.backpack

My journey towards a better way of investing started with a conversation with my dad in the early 80’s. I was in High School, and from time to time the former Smith Barney stock broker and I would talk about stocks. In one of those conversations, my dad said it really didn’t matter what you bought or why, and Wall Street research, analysis, and forecasting was largely not beneficial.

Based upon my dad’s advice, my investment philosophy started out as a do-it-yourself approach with very little emphasis on technical analysis and a high degree of emphasis on patience and diversification. When I started investing professionally for clients in 1994, I carried forward the same philosophy, primarily using well diversified mutual funds in carefully designed asset allocation strategies.

This approach worked well, but after the dotcom bubble and bust, I discovered two key problems:

1. Cost Matters: Up to this point, I had not made mutual fund expense ratios a significant screening factor. As the market deflated rapidly in 2000 and 2001, I discovered similarly invested clients were experiencing very different results. The only difference between the clients who were mildly down and those who were wildly down was the cost of their investments.

2. Active Fund Managers Are Your Worst Enemy: Sometime during this period, I learned how to use a Morningstar X-Ray Report and it blew my mind. An X-Ray report delves deep into a portfolio, and exposes how funds are actually invested as opposed to how the fund managers SAY they are invested. I discovered mutual fund managers shift away from their stated objectives when they think the timing is right. When the dotcom bubble burst, some of my value funds were invested like growth funds! This type of behavior not only adds risk to the portfolio, it destroys the carefully-crafted asset allocation fund mix of a well-built portfolio. In other words, everything I was trying to create through portfolio construction was being destroyed by the trading bets of the active funds being used.

That was 15 years ago. Since then, I have continued to discover overwhelming proof of what my dad had realized 30 years prior: With stocks, it doesn’t really matter what you pick or why. What matters, is keeping costs down and maintaining exposure to the types of stocks that tend to outperform over the long run. Unfortunately, just buying index funds is an oversimplification and is not the right exposure (see Indexing vs. Low Cost Investing: There’s a Difference).

If you are interested in learning more about our investment philosophy, and the reasoning behind it, click on this short presentation: Investment Philosophy Narrated. And, as always, I am available for questions or comments.