Actively managed mutual funds certainly have their detractors in the business world, and apparently the chief investment officer at Yale University is among them. In a recent New York Times article, Yale CIO David Swensen issued a scathing critique of the mutual fund industry. He railed against both financial advisors and asset managers who conspire to make profits at the expense of retail investors who are encouraged to buy and sell at inopportune times. But is all this criticism really warranted?
Two steps forward, one step back
Swensen's primary complaint seems to be that mutual fund investors end up consistently underperforming the very funds they invest in, thanks to a combination of fund companies that tout top-performing funds and encourage performance-chasing and financial advisors who push clients into frequent trades to boost their own commissions. He advocates that investors stick to low-cost index funds and that the SEC actively encourage such a move. He also wants to see the SEC hold the mutual fund industry to a fiduciary standard.
Although I have long been a proponent of actively managed mutual funds, I think Swensen's critiques are spot-on. Do many mutual fund shops put profits ahead of shareholder interests? Yep. Do fund investors end up withlower returns than the funds they buy? Very often, yes. Do advisors and brokers push inappropriate investments on clients? Almost certainly.
But rather than throwing the baby out with the bathwater and painting all actively managed funds with the same negative brush, I think it helps to clarify the role that investors themselves play in this scenario.
From my perspective, the vast majority of the criticisms made in the NYT article all stem from one particular, extremely pervasive investor tendency: the inclination to chase performance. Almost everyone does it at some point. After all, it's hard to hold on to your losing or underperforming funds when those other funds over there are beating the pants off of the market! And while Swensen argues that fund companies play a part in the performance-chasing game by touting their recent returns or Morningstar star ratings, I don't think you can fault fund shops for simply advertising their performance.
I think the onus here is on investors to keep a long-term focus and to not chase the latest hot trend. The bottom line is that, barring an advisory relationship where you don't have physical custody of your assets, no one can make the buy-and-sell decisions except you. That means you are responsible for any deviation between published fund returns and the returns you actually achieve. It's not a fund company's job to tell you whether their funds are right for you at a particular point in the market cycle. Investors need to take responsibility for their performance-chasing ways.
After all, it's not debatable that investors' propensity to sell their funds after they have underperformed and buy funds after they have done well hurts them in the long run. As an example, we can look at one of the more volatile funds on the market, CGM Focus (CGMFX). The fund's rapid turnover and high-conviction strategy leads to very lumpy year-by-year results, leading investors to buy and sell the fund at the exact wrong times.
The fund did a smash-up job in 2007, posting gains of 80% on heavy exposure to top-performing energy and industrial stocks such as Schlumberger
Investor returns, or what folks actually earned in the fund given when they bought and sold, differ so widely from actual fund returns, it's astonishing. According to Morningstar data, while the fund earned a 10-year annualized return of 17.9% through July 2009, investors in the fund actually lost 16.8%, thanks to their movements into and out of the fund at exactly the wrong times.
Not only does this provide compelling evidence that chasing performance is harmful, but it also highlights the fact that investors may be better off with less volatile funds that don't inspire investors to buy and sell based on large swings in fund performance. But in the end, investors hold the responsibility for staying the course.
I can't argue with Swensen's prescription to eschew active funds in favor of low-cost index funds. For investors who don't care about having the potential to beat the market and want the most inexpensive investment vehicles money can buy, this strategy makes sense. If you are such an investor, index funds or exchange-traded funds make sense. Some of my favorite broad-market ETFs include SPDR S&P 500 ETF
But while index funds and ETFs can remove the impulse to chase performance in comparison with the market, they won't eliminate the urge to chase performance amongst asset classes. After all, investors are probably just as likely to move money to those areas of the market that are doing well (witness the inflows into emerging markets in recent years) at the expense of underperforming areas (such as high-quality domestic large-caps). And we know the pattern: When folks do this, they miss out when those underperforming corners of the market pick back up, as they usually do after periods of lagging returns. So again, the solution here is for investors to stick to their long-term asset allocation and have the dedication to avoid making changes based on short-term events or trends.
And lastly, Swensen is absolutely right that financial advisors often push clients into buying inappropriate investments or making unnecessary trades so as to increase profits. In my opinion, the commission-based model in the advisory business is a bad one. Investors should look for fee-based advisors or advisors who are not paid based on which investments you buy or how often you buy them. Holding the financial-planning business to a fiduciary standard is an idea that is long overdue.
So while the mutual fund industry does indeed have many problems and pitfalls, if investors are careful to choose the right funds and hold them for the long run, they can still come out ahead of the game.
Amanda Kish is the Fool's resident fund advisor for the Rule Your Retirement investment newsletter service. At the time of publication, she owned none of the funds or companies mentioned herein. The Motley Fool owns shares of Schlumberger, Wells Fargo, and Bank of America and has created a ratio put spread position on Wells Fargo.Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.