The Best Way to Win With Mutual Funds

All your life, the mutual fund industry has told you that investing in its funds is the best way to achieve financial success. While fund shareholders have seen their fortunes rise and fall, however, many of the companies that offer those funds have consistently found ways to make profits for their own businesses, both in good times and in bad.

Betting on the house
Any gambler knows that it pays to bet on the house. Just as investors in Wynn Resorts can count on the rules of table games to stack the odds in their favor against the casino operator's gambling customers, so do mutual fund companies prefer to avoid the uncertainty of investing in the financial markets. By taking a cut off the top, these companies have no direct exposure to the wild market movements that their fund-holding customers must deal with every day.

In particular, the model that most mutual fund companies use is a direct path to profits. Most funds charge a constant annual management fee that is completely unrelated to the performance of the fund. Whether the fund falls 40% in a year like 2008, or rises 50% in a bounce like last year's recovery, fund companies slowly but surely drain off your profits -- or take part of your capital, if the funds you own can't manage to make money for you.

The numbers don't lie
You can't fully appreciate the sheer magnitude of fund industry profits until you see them up close and personal. That's why you need to take a look at the following numbers, which come from some of the best-known public asset-management companies:

Stock

2008 Net Income

2009 Net Income

Net Profit Margin

Blackrock (NYSE: BLK  )

$784 million

$875 million

21%

Franklin Resources (NYSE: BEN  )

$1.59 billion

$897 million

27%

Brookfield Asset Management (NYSE: BAM  )

$649 million

$454 million

7%

T. Rowe Price (Nasdaq: TROW  )

$491 million

$434 million

26%

AllianceBernstein (NYSE: AB  )

$245 million

$167 million

89%

SEI Investments (Nasdaq: SEIC  )

$139 million

$174 million

19%

Source: Capital IQ, a division of Standard and Poor's.

That's a healthy chunk of cash on the bottom line for fund companies, especially during a period in which so many companies in other industries were losing huge amounts of money. Even within the financial industry, Citigroup (NYSE: C  ) lost $29 billion over that two-year period, reeling from falling interest income and losses from its trading activities.

Even more revealingly, nearly all of these companies made more money in 2008, the year of the stock market's big loss, than they did last year. That's due largely to the way the market played out; most of the damage to ordinary investors came late in 2008, so the asset base on which fees were taken was still relatively high during most of 2008. Then, in 2009, markets took time to rebound, so fees were calculated on a lower asset base for most of the year.

How to win
From one perspective, if you can't beat the fund companies, you might want to join them. The companies above have made excellent long-term investments for company shareholders, with average returns near or above 20% annually. Those numbers even put many casino stocks to shame.

But if you're a mutual fund investor, you shouldn't take the figures above as a sign that you have to stop investing in mutual funds entirely. Using mutual funds can still make a lot of sense for investors, but you have to be smart about it. In particular:

  • Watch the fees. The lower the fee, the less your fund manager is taking from your profits.
  • Hold your fund accountable. If your fund can't outperform its benchmarks by at least the amount it charges as a fee, then your fund's managers aren't earning their keep. Go to a low-cost index fund instead.
  • Pay for performance. Conversely, you may want to seek out funds that have a direct stake in the fund's returns. Some funds, for instance, earn more or less in management fees depending on whether they beat or fall short of their benchmarks. That puts a greater incentive on managers to do everything they can for their investors.

In a world in which middlemen seek to separate you from your hard-earned money, finding investments you can trust is more difficult than ever. Watching your fund company profit even when you're losing thousands in the markets is never pretty. By making sure you pay no more than you have to for a good mutual fund, you'll do your best to keep all your long-term profits for yourself.

Where's the market headed? Watch Fool contributors Morgan Housel and Alex Dumortier duke it out.

Fool contributor Dan Caplinger sticks with cheap funds. He doesn't own shares of the companies mentioned in this article. SEI Investments is a Motley Fool Stock Advisor recommendation. Brookfield Asset Management is a Motley Fool Global Gains selection. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy is always a winner.


Read/Post Comments (2) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 21, 2010, at 5:14 AM, Jahnavipat wrote:

    So a person could have bought, for example, 1000 shares of stock of the total 1,000,000 shares of stock of the company. The investor (the person who bought the 1000 shares of stock) now owns a part of the company and receives benefits or losses from that ownership of the company. The investor could sell the shares of stock to someone else. To make the selling of the shares of stock easier, the stockmarkets were formed and persons that knew how to buy and sell in the stockmarket were called brokers. Today there are all types of brokers: full service brokers, discount brokers, electronic broker firms, etc.

    Now we get to the work part. You must research, learn, and decide into which companies you want to invest. There are thousands of companies available to you. The decision making of where to invest is the hard part. Some people do this on their own, they buy books on the subject, they get companies annual reports, they look at the companies’ financial data, they work and work and work to make the right decisions. There are many methods, theories, and approaches to do this. That is why there are thousands of books and articles on the subject.

    http://www.financeandmarkets.net/best-mutual-funds.html

  • Report this Comment On August 31, 2010, at 7:36 AM, Jehnavi wrote:

    The investor (the person who bought 1,000 shares) is now a part of the business and receives the profit or loss of company property. The investor can sell shares to another person. For the sale of shares easier, stock markets have been trained and were able to buy and sell brokerage houses have been called. Today there are all kinds of brokers: full-service brokers, discount brokers, brokerage houses, electronics, etc.

    http://www.financemetrics.com/

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