Friday, February 4, 2011

Mutual Funds Have It All Wrong

Canada's largest national newspaper notes that "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.

4 comments:

Dustin said...

The point made above is well-taken. Net sales, in and of themselves, are by no means a reflection of successful fund management from an investor's point of view. However, it is a great metric to evaluate the full breadth of the management's effectiveness, particularly if you were Scotia Bank. It encompasses the effectiveness of the distribution model, which is driven by broker-fees,fund performance, and operational expenses. The question I have, relating to the above information, is what quantifiable information led you to point out this apparent discrepency? Are ScotiaFunds more reliant on their distribution model than their fund performance? What data shows this to be true? Is there something particular in their fund makeup that creates sub-market performance? I think the point about net sales, if and only if applied to an investor's perspective is valid, however, some additional analysis is needed to ascertain the applicability of the generalness of the point to the specific example at hand.

Paul said...

Saj,

are there any mutual funds you like?

Anonymous said...

Dustin, who's point of view would you rather investors use to compare funds? i don't see how sales have any benefit to an investor comparing funds at all! the only thing that matters is whether the fund's philosophy is acceptable to you and whether they have above average returns. thats it.

Saj Karsan said...

Hi Dustin,

Yeah this site is geared towards investors, so that is the perspective taken.

Hi Paul,

I don't really know any well enough to assert that I like them, so I can't really comment.

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