Friday, February 5, 2010

The Focus Of Mutual Funds

Last week, Canada's largest national newspaper ran an article with the headline "ScotiaFunds Is Tops". Presumably, one might expect this to mean that mutual funds commissioned by Scotia outperformed other funds when it comes to returns. Perhaps the article would then go on to compare the returns ScotiaFunds generated against those of the market, to see whether and by how much this group of funds generated in value for investors after fees. Unfortunately, these types of metrics are not at all what the mutual fund industry is focused on, and the content of this article illustrated that perfectly.

Instead of "Tops" (in the article's headline) referring to the fact that Scotia generated the best return, it referred to the fact that ScotiaFunds had the highest net sales! In fact, the article did not even mention the returns of the group of funds, either the absolute returns, the returns compared to peers, or returns relative to the market itself. What is mentioned in the article, however, is by how much assets under management grew for Scotia, and at what level assets under management currently stands.

Investors who pay attention recognize that the incentive structure of the mutual fund industry is not conducive to generating returns for investors: managers are paid based on sales, not investment returns. As a result, mutual funds are effectively marketing companies rather than investment funds.

Certainly, excellent returns do help market a fund, but there is enough wiggle room for managements in this area to throw off the majority of investors. For example, funds with below-average returns can simply be shut down, leaving the company's remaining funds looking terrific on a historical basis. This creates a survivorship bias in the results, and practically guarantees that future results will not be as good as those of the past appear to be.

Furthermore, fund returns are only a small component of the overall marketability of a fund. Paying high commissions to agents can result in fund sales, as many investors don't take the time to do the research themselves, preferring to take the advice of an "expert" or relationship manager. This advisor just gets a piece of the action, like a credit card processing service such as Paypal. Unfortunately, that "expert" is getting paid to push certain products, and investors who don't recognize this are probably not putting enough thought into their investment decisions.

When buyers purchase homes or cars, they do put in some time and effort to understand what they are buying. For whatever reason, many appear less inclined to do so when it comes to investing their savings. Those who are willing to do some research are at a distinct advantage as a result. These investors are able to buy undervalued stocks, closed-end mutual funds trading at large discounts, and ETFs with their significantly lower management fees.

1 comment:

Saqib said...

Hey Saj, good note. I completely agree, in fact a couple of my friends and I were having this exact same discussion that Mutual Fund Managers are paid based on A.U.M rather than value returned to the investor.

In fact, a lot of fund managers even 'window dress' their portfolios towards the end of reporting cycles to 'air brush' their results -- this is why you might notice large block trades on certain high performers in the market during particular periods of time. There are very few funds out there that focus on true returns, I think Gabelli is a good one among those, and PIMCO's portfolios are usually good too, although I believe they are more known for their focus on fixed income.