September 25, 1998

An Investment Opinion
by Dale Wettlaufer

Merrill Pros Lose to Individuals
An Open Letter to David Komansky, Merrill Lynch Chairman and CEO

September 25, 1998

Mr. David H. Komansky
Merrill Lynch & Co., Inc.
World Financial Center - North Tower
250 Vesey Street
New York, New York 10281

Dear. Mr. Komansky,

I am writing to you to comment on the campaign that Merrill Lynch (NYSE: MER) Vice-Chairman John Steffens has waged against the discount brokerage industry. What Mr. Steffens has to say about the discount brokers themselves doesn't really concern me at all -- what concerns me is Mr. Steffens' insulting attack on the intelligence and competence of individual investors who use Internet stock brokerage services.

According to the Wall Street Journal, Mr. Steffens says, "The do-it-yourself model of investing, centered on Internet trading, should be regarded as a serious threat to Americans' financial lives. This approach to financial decision-making doesn't serve clients well and it's a business model that won't deliver lasting value." Before I get to some pretty good evidence that Mr. Steffen's assertions are baseless, I want to point out that it sounds pretty disingenuous to me when a full-price brokerage house makes these sorts of assertions. This is especially true when the income of most of your brokers is decided by turnover of customer assets and not the investment return of customers.

But let's get to some hard data on how well customers of discount brokers do. According to a study dated April 1998, Professor Terrance Odean of the University of California at Davis shows that individual investors as a group are not really bad investors at all. This group of individuals, 60,000 households in all, was selected from the customer list of a single discount broker. Before taking expenses into account, the average performance of individual investors beat the market over a four year, 11-month period. Net of expenses, the average investor generated annual returns of 15.3%, underperforming the market by 1.8 percentage points per year. As a percentage of the index, the average investor's performance was 89.5% that of the index. Say we counted the normal 20 basis points (0.2%) annual expenses it takes an investor to get into an index-matching security or fund. Then the underperformance would be 1.6 percentage points per year.

Compare that with the average mutual fund manager. Most funds do not match the market, not even discounting loads and 12b-1 fees. But rather than looking at all the funds in the equity mutual fund universe, I wanted to look at how Merrill Lynch's funds have done over the last five years. I've taken out all short-term bond funds and other funds that are supposed to be lower risk. I have left in, however, international equity funds, balanced funds, and things like high-yield bond funds.

Versus a compound annual return of 18.75% for the S&P 500 over the last five years, here's how Merrill Lynch's funds stack up (data according to Bloomberg -- monthly from 9/30/93 to 8/31/98).

Basic Value...14.93%
Capital Fund...12.05
Consults International...4.04
Developing Capital Markets...-6.97
Dragon Fund...-21.59 (since 10/31/94)
Fund for Tomorrow...9.6
Fundamental Growth...21.27 (since 10/31/94)
Global Allocation...8.24 -- the symbol for this fund is "MALOX." Ironic, huh?
Global Holdings...6.7
Global Resources...-1.7
Global Small Cap...-1.92 (since 10/31/94)
Global Utility...11.17
Growth Fund...8.14
Healthcare Fund...16.54
International Equity...-1.3 (since 10/31/94)
Latin America...-15.8 (since 10/31/94)
Pacific Fund...0.36
Phoenix Fund...8.06
Special Value...8.59
Strategic Dividend...13.93

And don't forget, these funds have 5 1/4% loads and annual fees. But we'll give you the benefit of the doubt and compare the pre-expense returns of your best guns against the "average" individual investor using a discount broker.

The average for your funds, Mr. Komansky, is 5.11% annually, 13.64 percentage points below the S&P 500. As a percentage of the return of the S&P 500, Merrill Lynch's investors did a little better than one-quarter as well as they would have done investing in a low expense, no-load S&P 500 index fund. And these are the returns generated by your best employees when it comes to money management, one would think. What about your brokers who don't have to have any special degrees, need only to pass an easy Series 7 (I took and passed the test), and engage in professional education that's not that intellectually rigorous? Are they better money managers than your fund managers? I can't make that judgment, so I have a challenge for you.

I bet you $5,000 that a randomly chosen sample of 40,000 Merrill Lynch clients cannot outperform 40,000 randomly chosen clients of an online discount brokerage. The loser has to make a $5,000 donation to the charity of choice of the winner. This would be a five-year study, because we don't believe that investing results are significant unless measured over at least five years. It would be safe money for me to put a bunch of individual investors up against your money management pros, but we'll see how your clients do against a bunch of regular Fools.

If you are game, please contact me here at the Fool.

Sincerely yours,
Dale Wettlaufer