You may not have heard of him, but Louis Lowenstein spent many years annoying the elite of Wall Street on our behalf. A professor of business law and a former business executive, among other things, he spoke out against problems he saw in our financial systems. Lowenstein died earlier this month.
Here are some things I learned about him:
For starters, he issued cautions about short-term investing -- as we've done here in Fooldom for many years. What's so bad about short-term investing? Well, to me, it's almost an oxymoron, since the stock market is so unpredictable in the short term.
Anything can happen, even to stocks of healthy, growing companies, in the course of a month or even a year. Heck, look at the 2008 carnage among well-respected companies. Firms such as Agilent Technologies
Sounding fund alarms
Lowenstein took on mutual funds, too, penning the book The Investor's Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do About It. Don't get me wrong -- I acknowledge the many benefits of mutual funds and have invested a sizable chunk of my own assets in them. But as Lowenstein has pointed out, the fund industry has some, um, issues.
For example, as he noted, "[Fund] management companies are independently owned, separate from the funds themselves, and managers profit by maximizing the funds under management because their fees are based on assets, not performance."
Got that? The problem is actually multifaceted. For starters, when fund managers profit from fees more than performance, a key incentive is to make the fund as big as possible. A 1.5% fee levied on a $1 billion fund will bring in $15 million, which can become $30 million when the fund grows to an asset base of $2 billion.
It's true that performing well will attract more investors and their money, but it's also true that when a fund grows very big and might benefit from shutting its doors to new dollars, many funds keep those doors open in order to keep their fee income growing. So even when funds are performing poorly or abysmally, their managers are still collecting fees.
Yet, as a fund grows bigger, it would make more sense for its fees to fall, as its fixed costs are spread over a wider base. But many funds are slow to shrink their fees, if they do so at all. While fund assets rose 90 times between 1980 and 2004, from $45 billion to $4 trillion, the fees those funds charged rose nearly 130 times, from $288 million to $37 billion.
Fees can really eat up investor returns. Consider, for example, the Van Eck International Investors Gold (INIVX) fund, which sports an impressive five-year average annual gain of more than 16% and gives you exposure to shares of miners like Barrick Gold
Lowenstein also criticized high turnover in mutual funds and even in brokerage accounts, noting that Wall Street professionals make gobs of money by getting investors in and out of investments too frequently.
Lowenstein did more than just criticize, though. For example, he conducted a study of some value-oriented mutual funds that fared relatively well during the "disorderly boom-crash-rebound years of 1999-2003." He found that they owned much smaller portfolios than the average equity fund and turned over their portfolios six times slower than the average fund.
What to do
So how should investors put Lowenstein's wisdom to work? Well, be choosy. Yes, there are conflicts of interest aplenty in fund-land, but you can skirt some of them by looking for fund managers who "eat their own cooking" -- investing heavily in their own funds. That certainly gives them a meaningful incentive to perform well for their shareholders. You can also seek out low fees and applaud funds that actually lower their fees over time, or close their doors to new investors from time to time.
For pointers on finding some outstanding mutual funds, give our Motley Fool Champion Funds newsletter a whirl. A free 30-day trial includes full access to all past issues, including detailed analysis on each recommendation.
Longtime Fool contributor Selena Maranjian does not own shares of any companies mentioned in this article, but she has long admired Xerox and copy machines. The Fool owns shares of Legg Mason, which is a Motley Fool Inside Value recommendation. The Motley Fool is Fools writing for Fools.