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5 things the mutual fund industry doesn't want you to know
Category :- Investments

Author :- Peter Hodson 
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Posted on February 5, 2014, 5:00 pm
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An earlier column on mutual funds attracted a lot of commentary from my one-time colleagues in the business. They didn’t like someone, especially a former insider, saying bad things about their industry. But the problems exist and we promised we would detail some more of them, so here are five more to consider — industry wrath or not.The mutual fund business is a great industry — for the people that sell them. For investors, it’s not so good.

1. Bigger is certainly not better

Beyond a certain asset level, there are very little marginal cost savings to be had from a bigger mutual fund compared to a smaller fund. However, the industry’s goal is to get assets in the door so there is a drive to favour big funds.

Certainly, funds that performed well in the past tend to become larger as investors seek performance and are pushed by the huge marketing efforts by fund companies.

But as we know from direct experience, it is much harder to get good investment outperformance from a large ($1-billion-plus) fund. You can’t buy everything you want to with a large fund, and the market impact on sales/purchases really eats into performance.

Ask any fund manager, “If you were paid on fund performance only, would you want a $200-million fund or a $2-billion fund?” and the answer will always be the smaller fund.

The industry’s drive towards bigger funds is just not the best thing for investors.

2. Trailer fees

It is quite amazing that the majority of mutual-fund investors don’t know that fund companies pay their advisors simply to keep clients holding their mutual funds. Sometimes this fee can amount to 1% annually.

The fee is supposed to be for service, but what if a client should really go to cash or switch to a lower-fee fund? Will the advisor look at things objectively if their income is reduced by such a change?

This is clearly a conflict, but don’t expect any changes to the compensation model anytime soon.

3. Large clients pay more

In the mutual fund world, it really doesn’t take more effort to manage a $900-million fund than it does to manage a $400-million fund. Yet a client with $90,000 in the fund will pay twice as much in gross management fees as a client with $45,000 in assets.

Admittedly, some advisors and fund companies have scalable fees, but the levels only typically kick in at super-wealthy levels, usually above $500,000 in assets, if not more.

The fact that there isn’t a discount on fees for larger clients might be unique in the business world: It simply doesn’t make any sense to charge your biggest clients more than your smaller clients.

4. Closet indexing

If you have ever taken a look at the Top 10 holdings of the biggest mutual funds in Canada, you will find almost the same stocks — a couple of banks, a couple of utilities, a couple of cellphone companies, and maybe Potash Corp. of Saskatchewan Inc. or Goldcorp Inc. thrown in as well.

Most large Canadian funds above $1-billion pretty much own the exact same things, so investors end up with index-like performance, but pay much more in fees than they would with an equivalent ETF product.

Most fund managers — rightly so — like their jobs, and straying too far from the index is a risky proposition for them. If they are wrong, they look pretty bad. But hugging the index and not straying too far from it only ensures: a) job security for the managers, and b) mediocre fund performance.

5. Overdiversification

If you look at your mutual fund statements, you will see it likely holds hundreds of different companies. Once, I counted 500 different positions in a single mutual fund.

But numerous independent studies over the years have proven that the investment benefits of diversification are severely diminished once you get beyond just 20 companies. Not only is it impossible for a fund manager to fully keep track of 200 different companies, it also adds nothing to the fund¹s risk/return profile. Next time your manager mentions that he/she owns 100 stocks, ask them, “Why?”

Consider these facts — and the five covering the industry’s excessive fees and bonuses, short-term focus, unnecessary asset gathering, and needless deal buying and stock trading from our earlier column — the next time you are thinking about investing in mutual funds.

There are some good funds out there and, yes, they have some benefits. But we still have enough bad points to ensure another future column about the negative aspects of the industry.





Comments : Peter Hodson, CFA, is CEO of 5i Research Inc., an independent research network providing conflict-free advice to individual investors
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