Worse was still to come. Donald Regan (who later became Treasury Secretary) took over the reins at Merrill in 1968. The markets were buoyant that year. Then, as now, tech stocks were all the rage and trading volume was high, at least by the standards of the day. Brokers at other firms, all of whom worked on a commission basis, were making money like it was going out of style. But there was no joy at Merrill, where the brokers were salaried. Defections mounted, and within a short time after a.s.suming power, Regan was forced to join the rest of the industry and allow his troops a piece of the commission action.
Thus was Merrill"s legacy betrayed, along with its clients. In the short run, Regan had saved the company; the defections stopped and profitability returned. Trading volume at Merrill skyrocketed as it became just like everyone else. At the same time, the company ceased treating its clients" interests as a sacred trust and turned them into cash cows to be methodically milked for commissions.
This was the end of the trail for the modern retail brokerage firm as a socially useful enterprise. It fell to others, notably Ned Johnson at Fidelity and Jack Bogle at Vanguard, to later champion inexpensive access to the markets for the average investor. We"ll examine that story-the rise of the mutual fund industry-in the next chapter.
Stockbroking"s Seamy Underside Few industries are as opaque to serious study as retail brokerage. The most basic data pertaining to broker background and performance, portfolio turnover, and expense simply do not exist. It is truly astonishing that the SEC, charged with protecting the public interest in the capital markets, collects little information about the level of performance, fees, turnover, and other expenses in the industry. And it seems to have little interest at all in the training and level of knowledge of brokers as a group. It is a sad fact that you can pa.s.s the Series 7 exam and begin to manage other people"s acc.u.mulated life savings faster than you can get a manicurist"s license in most states.
The brokerage industry itself is extremely tight-lipped about fees, performance, and corporate practices. Because of this, we are forced to look at the indirect evidence-anecdotal descriptions of the qualifications, training, incentives, and culture at the big wirehouses. Even the most cursory study reveals that there is very good reason for the secrecy.
The first observation is the most obvious. As we"ve already discussed, your investment return, on average, will be the market return minus your expenses. Does it have to be said that your broker has an incentive to keep those expenses-the nearly exclusive source of his income-as high as possible? For proof, just look at what brokers do and don"t recommend to their clients. Rarely are Treasury securities recommended, because they carry minuscule commissions. And you will almost never see a broker suggest a no-load fund.
Princ.i.p.al Transactions Are Not Principled Transactions There is a lot of confusion about one source of a broker"s income-spreads. A stock or bond does not have one price, but two: the lower "bid" and the higher "ask." You buy at the higher ask price and sell at the lower bid price. The difference between the two is small for heavily traded stocks, typically less than 1% of the purchase price, and large for thinly traded stocks-as much as 6% of the price. Thus, every time the investor buys, then later sells a stock or bond, he loses the spread between the bid and the ask price. The spread goes to the "market maker," the person or company that at all times maintains an inventory of the stock or bond, to allow for smooth trading.
In many cases, the broker is acting as an "agent," which means that he and his company are not not the market makers. Instead of getting the spread, they trade with the market maker and collect a commission for this service. But frequently the broker acts as "princ.i.p.al," meaning that his firm is, in fact, the market maker, buying from and selling to its own clients. In this case, they do collect the spread and are not allowed to also charge a commission. (Although illegal, the charging of a commission on a princ.i.p.al transaction-"double dipping"-is not a rare occurrence.) This is usually noted on the trade confirmation as a "princ.i.p.al transaction." And here is where most of the skullduggery occurs. the market makers. Instead of getting the spread, they trade with the market maker and collect a commission for this service. But frequently the broker acts as "princ.i.p.al," meaning that his firm is, in fact, the market maker, buying from and selling to its own clients. In this case, they do collect the spread and are not allowed to also charge a commission. (Although illegal, the charging of a commission on a princ.i.p.al transaction-"double dipping"-is not a rare occurrence.) This is usually noted on the trade confirmation as a "princ.i.p.al transaction." And here is where most of the skullduggery occurs.
Profit margins are quite high with princ.i.p.al transactions-the client almost never finds out that the stock or bond he just purchased was acquired from another of the firm"s customers at a much lower price. Clients are told simply that "there is no commission" on princ.i.p.al transactions, as if they have just benefited from an unexpected bit of corporate largess.
Even worse, many wirehouses" princ.i.p.al transactions take the form of "specials"-undesirable stocks and bonds underwritten or purchased in quant.i.ty by the firm and pa.s.sed off on clients via brokers touting glowing research reports from the company"s crack a.n.a.lysts. Brokers who can unload large amounts of such toxic waste on their unsuspecting clients are rewarded with bonuses and prizes (typically exotic vacations). I have never seen a broker-run account that was not laced with obscure, illiquid stocks and bonds carrying high commissions and spreads; these securities have "special" written all over them. Sadly, clients are never told that such transactions involved a special.
Most brokerage houses also sell mutual funds. These almost always carry a sales fee, or "load." As we"ll see in the next chapter, load funds do not perform any better than funds sold without a sales fee-known as "no-load funds." Yet, brokers almost never recommend no-load funds, for obvious reasons.
Have you ever wondered how your broker comes up with his recommendations? Do you think that he carefully a.n.a.lyzes the market, stock by stock, looking over each company"s fundamental financial data, industry trends, and marketing data? Hardly. The average broker is a salesman, not an expert in finance. Your broker"s stock picks come straight from the "squawk box," a loudspeaker that connects every branch to headquarters. Several times a day, the firm"s industry a.n.a.lysts and strategists report their conclusions simultaneously to thousands of brokers around the country. Later that day, or that week, you get the hot tip from your broker.
The problem is that you, as a small retail customer, are last in line. The large inst.i.tutional players-pensions, privately managed money, and mutual funds-have received the news long before you, and the price of the stock has already been bid up by the time your broker phones you with the recommendation. In this poker game, you"re the patsy. But you"re in good company, because the a.n.a.lyst"s recommendations are already tainted. The world of brokerage stock a.n.a.lysis is a small, inbred one. At its center are the corporate officers who dole out financial information about their companies to the a.n.a.lysts. Not only are all of the a.n.a.lysts getting their information from the same place, but their access to it is exquisitely dependent on the good will of the company.
If a.n.a.lysts are too critical of the companies they are covering, that vital information-the lifeblood of their craft-could dry up in a heartbeat. So the recommendations parroted back to you via the a.n.a.lyst, through the squawkbox, to your broker, are likely to have had most of their punches pulled.
The a.n.a.lyst-to-broker-to-you flow of information is flawed in another serious way-the connection that the brokerage firms have with their investment-banking arms, which underwrite new issues of stocks and bonds. These operations are enormously profitable and are a minefield for the unsuspecting investor. We"ve already come across specials-often newly underwritten stocks and bonds that have not sold well. Less overt, and much more widespread, is the compromised relationship between the brokerage"s a.n.a.lysts, who are telling the brokers what to recommend to the clients, and the firms they cover, that also stand to gain from a broker"s recommendations.
The a.n.a.lysts feel immense pressure to recommend the stocks of companies that their firm underwrites, or whose underwriting business they are seeking. a.n.a.lysts are frequently threatened with discipline, or worse, for making unfavorable recommendations about such companies, and their recommendations are laced with euphemisms such as "outperform," "acc.u.mulate," or "hold." Because it may anger a potential underwriting client, the word "sell" does not seem to be in their vocabulary. "Hold" is the worst it gets when it comes to recommendations.
The significance of this complex relationship is that you can"t trust your broker"s recommendations. Does the a.n.a.lyst who is feeding them to the broker really believe in his buy recommendations? Or is he simply trying to curry favor with the company for the sake of its investment banking business? Does the a.n.a.lyst believe that you should be selling some of your names but is afraid of offending the company involved because the brokerage firm wants to get or keep its investment banking business? These issues got completely out of hand in the latter stages of the dot-com mania a few years ago. During this period, enormous underwriting profits dangled before the investment bankers" eyes, and the interests of the retail clients were completely forgotten. Investors found out too late that the recommendations of the big wirehouses" most prestigious technology a.n.a.lysts were driven more by the desire to garner underwriting business than to serve the interests of the clients.
Given such perverse incentives, it should not surprise you that the result is systematic abuse. Seen from the inside, the brokerages appear geared almost entirely to excessive trading and the resultant fees and spreads. The most shocking aspect of the brokerage business is that brokers almost never actually calculate the investment results of their clients, let alone reflect on methods for improving them. In recent years, their modus operandi modus operandi has changed somewhat. "Wrap accounts," in which a set fee is charged for portfolio management, including commissions, are gaining in popularity. Another innovation is the inst.i.tution of accounts allowing unlimited trading, also for a fixed fee. But at the end of the day, most wirehouses operate on the "2% rule"-collect 2% in fees and commissions, overt or hidden, on your clients" a.s.sets, or you"re out. has changed somewhat. "Wrap accounts," in which a set fee is charged for portfolio management, including commissions, are gaining in popularity. Another innovation is the inst.i.tution of accounts allowing unlimited trading, also for a fixed fee. But at the end of the day, most wirehouses operate on the "2% rule"-collect 2% in fees and commissions, overt or hidden, on your clients" a.s.sets, or you"re out.
My experience is that the 2% figure is extremely conservative-it is not unusual to see accounts from which as much as 5% annually is extracted. You say 2% doesn"t sound like much? If the real return of your portfolio over the next few decades is 4%, you"re giving your broker half of that, leaving 2% for yourself. Compounded over 30 years, that means you are left with 55 cents for every $1 you should have had.
There are only two studies that have actually looked at the level of returns and turnover in the average brokerage account. The first, by Gary Schlarbaum and his colleagues at Purdue and the University of Utah, found that, superficially at least, the brokerage accounts they examined did seem to obtain the market return, even after expenses. Unfortunately, their study covered the period from 1964 through 1970. During these seven years, small stocks outperformed large stocks by 8% per year. Since small investors tend to hold small stocks more heavily than inst.i.tutional investors, their returns should have been much higher. But because of the relatively unsophisticated methodology used at that time, the true amount of the shortfall is impossible to determine.
More disturbing was the amount of trading taking place in these accounts. A total of 179,820 trades were executed in 2,506 accounts over the course of seven years. On average, that meant 76 trades per account, or about 11 per year. At an average of $150 per trade, this amounts to $1,650 per year. Since the median account size was approximately $40,000, that"s 4% skimmed off the top annually. Thirty years ago, trading was expensive and the average account usually did not hold many stocks. So these accounts were being turned over as much as 100% per year. An even better idea of the amount of turnover is provided by the number of accounts with no trading in the seven-year period: just 17 of the 2,506. Not many buy-and-holders in that crowd.
What does 4% per year in commissions mean? Theoretically, after a few decades, your broker could wind up with more of your money in his bank account than you have in yours. This is demonstrated in Figure 9-1 Figure 9-1, in which it is hypothetically a.s.sumed that you and your broker can both earn 8% per year, but that he takes 4% of your portfolio each year, leaving you with a 4% return. Meanwhile, he can invest his commissions at 8%. After 17 years, he has acc.u.mulated more than you have, and after 28 years, he has twice as much.
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Figure 9-1. You and your broker: 8% return, 4% fees. You and your broker: 8% return, 4% fees.
The other major study, done by Brad Barber and Terrence Odean, at "a large discount broker" (think Charles Schwab) showed that the average portfolio turned over about 75% of its contents each year, and that the most active 20% of traders turned over an average of 258% of their stocks each year. (In other words, each position was traded, on average, every five months.) For every 100% of turnover, investors lost 4% of return. Please note that this was at a discount discount brokerage, where the commissions were much lower than at a typical full-service brokerage, and where brokers are not paid a slice of commissions. brokerage, where the commissions were much lower than at a typical full-service brokerage, and where brokers are not paid a slice of commissions.
Even the most casual of interactions with brokers and their current and former clients reveals several highly bothersome patterns: * Brokers clearly occupy the lowest rung of investment sophistication and expertise. On the top rungs are the inst.i.tutional money managers and brokerage house industry a.n.a.lysts; they are well-acquainted with the basics of modern finance. My experience is that many of these wirehouse aristocrats actually invest their personal portfolios in index funds. Unless you are a large client (or, as you would be known in the trade, a "whale"), you will never chat with one of these folks. And, of course, you will never actually have your money managed by them. The average broker, on the other hand, usually knows nothing about the relationship between turnover and return, how to build an efficient diversified portfolio, or the expected return of various a.s.set cla.s.ses. I have yet to meet a broker, for example, who is aware that value stocks historically have had higher returns than growth stocks. The plain fact is that they are not trained by the brokerage houses to invest-they are trained to sell.* Brokers pay almost no attention to the returns their clients earn. It is rare to come across one who routinely calculates his clients" annual returns, let alone considers what these data might mean. In fact, the corporate culture at the major brokerage houses completely ignores what we"ve been doing in these pages-the objective, evidence-based scientific investigation of what actually works what actually works. If you catch a broker off-guard, particularly after a few drinks, and ask him how much time he spends discussing with his peers how to improve his clients" returns, you are likely to get a very blank look.* Brokers do undergo rigorous training, sometimes lasting months-in sales techniques. All brokerage houses spend an enormous amount of money on teaching their trainees and registered reps what they really need to know-how to approach clients, pitch ideas, and close sales. One journalist, after spending several days at the training facilities of Merrill Lynch and Prudential-Bache, observed that most of the trainees had no financial background at all. (Or, as one used car salesman/broker trainee put it, "Investments were just another vehicle.") Although there were a few hour-long cla.s.ses on the basics of stocks and bonds, these sessions were geared toward keeping the green recruits just one step ahead of their clients. Most of the training time was spent in a language lab-like setting, followed by role playing, in which sophisticated sales scripts were demonstrated and discussed. The modern broker is taught not to be pushy but, rather, to draw prospective clients into discussions of their worries and needs. Thirty years ago, a broker was taught to say, "AT&T is poised for a big move, and we at E.F. Hutton think you should buy 200 shares." Now, trainees are taught this approach: "Mr. Smith, what is your most pressing concern?" In other words, the Zen of selling less, so that they can sell a lot more. At the final sessions, Merrill hopefuls were encouraged to get their real estate and insurance licenses and make a minimum of 180 cold calls per week.* What do brokers think about almost every minute of the day? Selling. Selling. And Selling. Because if they don"t sell, they"re on the next train home to Peoria. The focus on sales breeds a curious kind of ethical anesthesia. Like all human beings placed in morally dubious positions, brokers are capable of rationalizing the damage to their clients" portfolios in a mult.i.tude of ways. They provide valuable advice and discipline. They are able to beat the market. They provide moral comfort and personal advice during difficult times in the market. Anything but face the awful truth: that their clients would be far better off without them. This is not to say that honest brokers who can understand and manage the conflicts of interest inherent in the job do not exist. But in my experience, they are few and far between. After all, what is best for the client is to keep investment costs and turnover as low as possible, which also minimizes a broker"s income. Not infrequently, brokers become disenchanted and leave the business. Occasionally, they will even become fee-only advisors, whose compensation is not tied to trading. (For the record, I am a princ.i.p.al in a fee-only advisory business and will freely admit that the fees charged by many in the trade are as excessive as that seen at the brokerage houses.) But, by definition, you are not going to find such a person at a full-service brokerage house unless you happen to engage his services right before he quits.
Brokers will protest that in order to keep their clients for the long haul, they must do right by them. This is much less than half true. It"s a sad fact that in one year a broker can make more money exploiting a client than in ten years of treating him honestly. The temptation to take the wrong road is more than most can resist.
The message of this chapter is the clearest of the book: Under no circ.u.mstances should you have anything to do with a "full service" brokerage firm. Unfortunately, this is frequently more easily said than done. Your broker is often your neighbor, fellow Rotarian, or even family. And eventually, by design, they all become your friend. Severing that professional relationship, although necessary to your financial survival, can be an extremely painful process.
Your journey through and beyond this book will allow you to manage your money without outside help. But if you do engage an advisor, make sure that he or she is compensated only through fees that you pay, and not from sales fees and payments by the funds or other investments they sell. The reason for this is simple: you do not want anyone near your money-advisor or broker-whose compensation is tied in any way to his choice of investment vehicles.
10.
Neither Is Your Mutual Fund We"ve just seen what treacherous territory the first leg of the investment business-the brokerage industry-is. The second leg, the mutual fund industry, provides less hostile terrain. Unlike the retail brokerage business, you actually have a chance of emerging intact from your dealings with the mutual fund business. While there are pitfalls a-plenty in this playground, they are much easier to see and avoid.
Loading the Dice Against You As we"ve already discussed, the mutual fund-an investment product that makes highly diversified portfolios of stocks and bonds available to the smallest of investors-first began to transform the financial landscape in the 1920s. The excesses and imperfections of this early period were ironed out by the Investment Company Act of 1940, resulting in the creation of the relatively trouble-free, modern "open-end" fund, whose shares can be created or retired at will by the company to accommodate purchases and sales, as opposed to the "closed-end," or exchange-traded, 1920s investment trust, with shares that cannot be easily created or retired. But even the modern mutual fund scene is far from perfect.
The first and most obvious mutual fund trap to avoid is the load fund. These are usually sold by brokers or as insurance vehicles, carry a sales fee, and frequently also attach other ongoing charges designed to transfer wealth from you to whomever sold you the fund. These sales fees can be either front-loaded ("A-shares," paid upon purchase), back-loaded ("B-shares," paid upon sale), or be ongoing.
What do you get for the sales fee? Less than nothing. In Table 10-1 Table 10-1, I"ve tabulated the ten-year returns for funds that have a sales fee (load funds) and those that have none (no-load funds) for each of the nine Morningstar categories. The average load fund return is 0.48% per year less less than that of the average no-load fund. This is mostly accounted for by the 12b-1 fees added into the fund expenses. What are 12b-1 fees? They are an additional level of expense allowed by the SEC in order to pay for advertising. The theory is that this fee allows the fund to build up a.s.sets, thereby increasing its economy of scale, and reducing its fees. As you can see from than that of the average no-load fund. This is mostly accounted for by the 12b-1 fees added into the fund expenses. What are 12b-1 fees? They are an additional level of expense allowed by the SEC in order to pay for advertising. The theory is that this fee allows the fund to build up a.s.sets, thereby increasing its economy of scale, and reducing its fees. As you can see from Table 10-1 Table 10-1, this is a fairy tale. Even after subtracting the 12b-1 fees from the expense ratios of the load funds, their expenses are still higher than those of the no-loads.
Table 10-1. Load Fund versus No-Load Fund Ten-Year Performance and Fees, April 1991 to March 2001 Load Fund versus No-Load Fund Ten-Year Performance and Fees, April 1991 to March 2001 [image]
Even worse, the expenses and returns of load funds calculated in Table 10-1 Table 10-1 do not take into account the load itself. These typically run about 4.75%. Amortize that over ten years, and you"ve lost yet another 0.46% of return per year. do not take into account the load itself. These typically run about 4.75%. Amortize that over ten years, and you"ve lost yet another 0.46% of return per year.
Who buys this rubbish? Uninformed investors. Who sells it to them? Brokers, investment advisors, and insurance salesmen. Is it illegal? No. But it should be.
A close relative to the load mutual fund is the variable annuity. These are sold by insurance companies and carry an insurance feature. Like load funds, most come with high sales fees and ongoing insurance charges that are often higher than those of load funds. These products are not bought-they are sold. Their only advantage is that they compound free of taxes until they are redeemed. This tax advantage, however, is only rarely worth the c.u.mulative cost of the fees. To add insult to injury, a large chunk of these are sold by insurance agents, financial planners, and brokers for retirement accounts, where the tax deferral is unnecessary. Consider a recent advertis.e.m.e.nt from Kemper Annuities & Life in Financial Planning Financial Planning magazine, a trade publication for investment advisors: magazine, a trade publication for investment advisors: Now an annuity that keeps paying, and paying and paying and paying and paying and paying . . .
The advertis.e.m.e.nt goes on to explain how the product being pushed, the Gateway Incentive Variable Annuity, pays the salesman a 4% upfront commission plus a 1% "trail" fee each year. The ad urges the magazine"s investment-professional readers to "Find out more about the annuity that keeps paying and paying and paying . . ."
A great deal, no doubt, for the salesman. But not for the person buying one of these beauties, who, after first paying a 4% sales fee, then keeps paying the 1% "trail fee" each and every year. My message here is obvious: steer clear of mutual funds and variable annuities with sales loads and fees. Buy only true no-load funds and annuities that do not carry fees of any type, including 12b-1 fees. The major no-load companies are Fidelity, Vanguard, Ja.n.u.s, T. Rowe Price, American Century, and Invesco.
Into the Sunlight, But Not Quite Out of The Woods Get the load fund and variable annuity pitfalls out of the way, and you"re almost home. The most obvious difference between the mutual fund and retail brokerage business is the amount of sunlight. The transparency of the fund industry is simply breathtaking. Just by opening your daily newspaper, you can compare the performances of thousands of stock and bond funds. With a little more effort, you can get a pretty good idea of the expenses incurred by each fund. (If you want to know everything there is to know about any given fund, treat yourself to a single issue of Morningstar"s Principia Pro fund software for $105. A warning: This is a highly addictive package, and you may not be able to buy just one.) Imagine what would happen if you called your local brokerage and tried to get the performance and expense data on each of its brokers. If you were lucky, they would m.u.f.fle their laughter and politely suggest that you mind your own business.
This availability of information means that the fund company"s interests are much more closely aligned with yours. Given the ubiquity of fund performance information, fund investors are highly sensitive to short- and intermediate-term fund returns. Unlike the retail brokerage world, funds pay exquisite attention to investment performance.
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Figure 10-1. Year 2000 returns for 2,404 U.S. large-cap mutual funds. Year 2000 returns for 2,404 U.S. large-cap mutual funds.
But you and your fund company are still not quite on the same team. There is one key area where your interests and its diverge: management fees. In order to understand this, take a look at Figure 10-1 Figure 10-1. What I"ve plotted is the performance of the 2,404 domestic large-cap funds in 2000. Notice the enormous amount of scatter in fund performance for that year-310 funds gained more than 20%, and 223 funds lost lost more than 10%. The difference in annual performance among funds is so large that investors usually don"t notice if the fund company slices off an extra half a percent in fees. more than 10%. The difference in annual performance among funds is so large that investors usually don"t notice if the fund company slices off an extra half a percent in fees.
The companies understand this all too well: "You know, last year was a good one. The shareholders won"t care if we raise our management fee a bit. Why not?" So fees creep upward; between 1981 and 1997, the expense ratio for the average stock fund rose from 0.97% to 1.55%. This slightly overstates the case, as a lot of small, inefficient funds are included in this statistic-the "dollar weighted" fee average has not risen as dramatically-but the upward trend is clear. Over the past decade, the explosion of a.s.sets under management should have reduced reduced fees via economies of scale. This increasing fee trend is nothing short of scandalous. fees via economies of scale. This increasing fee trend is nothing short of scandalous.
Gunning the Fund Consider Fidelity Investments, which currently has more than $600 billion in a.s.sets under management. The year 2000 was not a good one for "Fido." None of its stock funds was one of the 310 in the large-cap universe that returned more than 20%. In fact, only 22 of their 72 large-cap stock funds made any money at all. The best, its Dividend Growth Fund, gained 12.25%. Nothing to write home about, but still better than the performance of the average large-cap fund, which lost about 6%.
So what does Fido do with the bad hand dealt it in 2000? Advertise the Dividend Growth Fund to death. The average fund investor, not realizing that past performance does not persist, sees the ads and buys the fund, no matter what its fees. After all, if the fund beat its peers by 18% in a given year, what difference does a little extra expense make?
Inside the Fidelity organization, this tactic is known as "gunning the fund." The first and best-known example occurred almost two decades ago. Unlike 2000, 1982 and 1983 were good years for Fido, particularly for a 30-year-old manager named Michael Ka.s.sen. His Select Technology Fund returned an amazing 162% for the one-year period ending June 1983. Until that point, Fido"s reclusive chief, Edward Crosby ("Ned") Johnson III, had been reluctant to use the press. But persuaded by one of his lieutenants, he instructed Ka.s.sen to cooperate for a cover story in Money Money, to the point of posing outdoors in the middle of a Boston February for several hours with shorts and squash racket.
This headline accompanied Ka.s.sen, his racket, and playing shorts in the next issue: "How to Invest in Mutual Funds. They"re the Safest Surest Way to Invest in a Surging Market." What happened next exceeded Fido"s wildest dreams. Within several weeks, new investors poured so much money into the fund that it tripled in size to $650 million, an enormous sum in those days.
Gooseb.u.mps aside, Ka.s.sen himself was somewhat less than ecstatic. It was nearly impossible for him to effectively deploy so much cash so fast in the relatively small companies on which his fund focused. Because of the subsequent collapse of the tech market, new shareholders got a very steep tuition bill from the College of the Capital Markets. Over the year following the peak inflow in mid-1983, the fund lost almost a quarter of its value.
This sequence highlights what I call the "mutual fund hierarchy of happiness." At the top of the pyramid is the fund family. Fidelity collected more than 1% in fees and 3% in front-end loads on Select Technology"s $650 million in a.s.sets, no matter how it performed. The fund manager was less happy: he was now faced with the impossible job of attempting to invest a mountain of cash rapidly in a small corner of the market, a setup for incurring huge market impact costs, which we discussed in Chapter 3 Chapter 3. Fortunately, his pain was eased by a high salary and the knowledge that as a newly minted superstar manager, he could demand even higher compensation, lest he peddle his scarce "talents" elsewhere.
At the bottom of this pyramid were, and are still . . . the shareholders. About the only thing performance-chasing investors have going for them is the faint glow of a.s.sociation with the soon-to-disappear notoriety of their fund manager. Weighing much more heavily on the other side of the scale is the possibility that the fund company might not be able to resist piggybacking higher management fees on its new popularity, the likelihood that the new shareholders have invested in a sector or style that has just topped out, and the certainty that their a.s.sets will be invested with a maximum of market impact.
The subsequent history of Fidelity Select Technology is instructive. After garnering nearly $1 billion dollars in a.s.sets in 1983 and 1984, the tech market turned stone cold, underperforming the S&P 500 by an average of 20% in each of the next six years. By 1989, fund a.s.sets had fallen to just $71 million. At that point, the fund"s performance turned around, and it gradually began to acc.u.mulate a.s.sets again, finally reaching the $1 billion mark in 1998. In that year, it beat the S&P 500 by 66%, and in 1999, as the dot-com mania heated up, by 96%. Within 12 months, a.s.sets quintupled to $5.2 billion, just in time for the tech collapse of 2000.
The story of Select Technology is emblematic of the nature of fund flows. First, they are most often contrary indicators-funds in high-performing sectors of the market tend to attract great piles of a.s.sets. In industry parlance, this is known as "hot money": a.s.sets thrown by naive investors at high past performance. It is more often than not a sign that the top is near. And even if it isn"t, it certainly serves as a drag on the performance of the funds, which are faced with deploying a large amount of capital in a fixed number of existing company shares.
Second, and most important, it highlights the conflict of interest between the investors and the fund company. Just as the brokerage firms exist to make clients trade as much as possible, the fund companies exist for one purpose: to collect a.s.sets, no matter how poorly their funds subsequently perform.
Most fund shareholders are "hot money" investors, buying high and selling low, as Select Technology"s hapless plungers did in the 1980s. Ned Johnson"s special genius is his ability to pander to the public"s desire for an endless number of investment flavors-of-the-moment. You say Argentine and Turkish bonds are all the rage and you want a fund investing in emerging markets debt? You"ve got it. Southeast Asian Stocks? Coming right up. Wireless? Nordic? Biotech? No problemo. "We were in the manufacturing business. We manufactured funds," was how one Fido executive put it. (These were funds, by the way, that few of Fidelity"s princ.i.p.als and employees would ever dream of owning themselves.) Not only was this system wildly successful at garnering capital; it functioned as a veritable roach motel-money checked in, but it never checked out. After Fido shareholders had gotten burned by last year"s hot fund, they would redeem their a.s.sets into a Fidelity money fund and eventually reinvest them in yet another one of Ned"s 231 flavors.
Finally, I can"t help but mention the Morningstar Unpopular Funds Strategy. Since Morningstar is located in Chicago and staffed by a sports-loving crowd, they have a special affinity for losers. Every year since 1987, they"ve used the fund money flows discussed above to identify the most popular and unpopular fund categories. They then follow the average performance of the three most popular and unpopular fund groups forward for three years. Eight out of nine times, the unpopular funds beat the popular funds, and seven out of nine times the unpopular funds beat the average equity fund. Most tellingly, the popular fund categories also lagged the average equity fund seven of nine times. I certainly don"t recommend this as an investment strategy, but it"s an excellent example of the dangers of chasing performance, because of the tendency for a.s.set cla.s.ses to "mean-revert," that is, to follow good performance with bad, and vice versa.
Watching the Cookie Jar As you can see, the conflict of interest between you and your fund company is just as direct as that between you and your broker. You are engaged in a zero-sum game with both-every dollar in fees and commissions paid to a fund company or broker is a dollar irretrievably lost to you. But the brokerage industry has one big advantage over the fund industry; the river of cash flowing to the broker is much better hidden than the management fees paid to the fund company. A good a.n.a.logy would be the difference between a cookie jar placed in your child"s bedroom versus one sitting in the kitchen. The baked goods are going to disappear much more rapidly from the bedroom jar than from the one in the kitchen.
Whereas between 2% and 5% of the cookies are going to abscond from the average brokerage account each year, the fund companies can only get away with much less. Since their fees are published at regular intervals in the newspaper and in the annual reports they must send to you by law, there are few cookies (or fees) that can be hidden.
But you can still learn a lot about the relative integrity of the fund companies just by watching those jars. For example, almost all large fund companies offer an "equity income" fund, which specializes in large value funds sporting reasonable dividends. Vanguard"s equity income fund charges 0.41%; Fidelity"s, 0.67%; and Scudder"s, 0.87%. Each company also offers a large international-growth fund: Vanguard charges 0.53% for its; Fidelity, 1.05%; and Scudder, 1.12%. Each has a small-cap growth fund: Vanguard charges 0.42% for its; Fidelity, 0.80%; and Scudder, 1.70%. Finally, each offers a precious metals fund. Vanguard charges 0.77%; Fidelity, 1.41%; and Scudder, 1.81%.
I picked these four cla.s.ses at random, simply looking for equivalent funds offered by all three companies. What have we learned? That there are real cultural differences among fund families. Scudder just can"t keep its hands out of the cookie jar. (It is no coincidence that Scudder, before it was recently sold to Deutsche Bank, belonged to the same corporate parent as Kemper Annuities & Life, producers of the annuity that keeps paying, and paying, and paying.) Fido is a bit more restrained, but not by much. And Vanguard seems to be very well behaved. (None of the Vanguard funds I mentioned, by the way, are index funds, which charge even lower expenses. In order to make the comparisons apples-to-apples, all of the fees quoted above are for actively managed funds.) What accounts for the differences among the fund companies? Their ownership structures do. Nowadays, most fund companies are owned by large financial holding companies. In Scudder"s case it was owned by Zurich Scudder Investments, and then by Deutsche Bank. (Scudder, in fact, after helping pioneer international and no-load investing along with Vanguard, has of late changed names multiple times and is in the process of committing corporate suicide by converting to a load-distribution mechanism and looking for merger partners.) As such, fund companies exist solely to generate revenues for the parent company. Their primary goal is the same as Louis XIV"s famous directive to his tax collectors, "Extract the maximum amount of feathers from the goose, with the least amount of hissing." You, of course, star in this minor drama as the goose.
Fidelity"s structure is unusual for a financial organization of its size, because it is privately owned, mainly by Ned Johnson and family. The Johnson family must be less greedy than their corporate brethren; their fees tend to be just a smidgen less. Vanguard"s ownership structure, as we"ll soon see, is actually designed to encourage low low fees. fees.
Journalist Jason Zweig captured this problem best in a speech given to an industry forum in 1997, in which he began by noting, This February, two portfolio managers, Suzanne Zak and Doug Platt, left IAI, a fund company based in Minneapolis. As Suzanne Zak told The Wall Street Journal The Wall Street Journal: "It got to the point where I wanted to get back to the basics instead of being part of a marketing machine." And Doug Platt, whose father founded IAI, added: "My father retired over 20 years ago, and the firm"s structure and focus are entirely different from what it was then. IAI is basically a marketing company that happens to be selling investments IAI is basically a marketing company that happens to be selling investments."
Zweig then asked the partic.i.p.ants to consider whether they they were running an investment firm or a marketing firm. The differences, according to him, are many: were running an investment firm or a marketing firm. The differences, according to him, are many: * A marketing firm advertises the track records of its hottest funds. An investment firm does not.* A marketing firm creates new funds because they can sell them, not because they think they are good investments. An investment firm does not.* A marketing firm turns out "incubator funds," kills off those that do not perform well, and advertises the ones that survive. An investment firm does not.* An investment firm continually warns its clients that markets sometimes go down. A marketing firm does not.* An investment firm closes a fund to new investors when it begins to incur excessive impact costs. A marketing firm does not.* An investment firm rapidly reduces its fees and expenses with increasing a.s.sets. A marketing firm keeps fees high, no matter how large its a.s.sets grow.
By Zweig"s definition, only about 10% of mutual fund companies are investment firms. The rest are marketing firms. Buyer beware.
The 401(k) Briar Patch The nation"s fastest growing investment pool is the employer-sponsored, defined-contribution structure. The centerpiece of this scheme is the 401(k) system, with more than $1.7 trillion under management. These plans are wildly popular with employers since they are inexpensive to fund and administer. Further, they effectively shield employers from multiple types of liability. Unfortunately, most plans pay scant attention to expenses; the typical plan has overt costs of at least 2% per year. And that"s before we take into account the hidden costs from commissions and spreads, much of which accrue eventually to the fund companies. Why is so little attention paid to 401(k) expenses? Because the employers focus on the services provided by the fund companies, particularly in the record-keeping area, without considering or even caring about the true cost of these services to their employees.
Worse, most of the stock funds offered by the fund companies are heavily weighted with the large-cap glamour companies of the 1990s. As a result, there is inadequate diversification into other a.s.set cla.s.ses. Most plans have no index funds beyond the S&P 500.
The result of all this is breathtaking. Although it"s difficult to get a handle on the precise returns obtained by employees, the best available data suggest that 401(k) plans provide at least 2% per year less return than those earned in traditional "defined-benefit" plans. And these, as we"ve already seen in Figure 3-4 Figure 3-4, are no great shakes to begin with. (In fairness, it should be noted that the return of a traditional defined-benefit plan accrues to the employer, who, in turn, will be paying their retirees a fixed benefit.) The 403(b) plan structure, utilized by teachers, suffers from the same flaws. Worst of all are 457 plans, provided to certain public employees, with average total costs well in excess of 3% per year. Until recently, 457 funds could not even be rolled into IRA accounts at retirement/termination, although the 2001 tax legislation makes this possible for most 457 owners when they leave their employment.
What can you do if your employer has put you into one of these dogs? You really only have two choices, neither of which may be palatable or even possible: try to get the plan changed or quit and roll it over into an IRA.
The ascent of self-directed, defined-contribution plans-of which the 401(k) is the most common type-is a national catastrophe waiting to happen. The average employee, who is not familiar with the market basics outlined in this book, is no more able to competently direct his own investments than he is to remove his child"s appendix or build his own car. The performance of the nation"s professional defined-benefit pension management ill.u.s.trated in Figure 3-4 Figure 3-4 may not be spectacular, but at least the majority of managers delivered performance within a few percentage points of the market"s. Because of the substandard nature of most 401(k)s, the average employee is already starting out 2% to 3% behind the market. He will almost certainly fall even further behind because of the partic.i.p.ants" generalized lack of knowledge of three of the four pillars-investment theory, history, and psychology. Toss in the inevitable luck of the draw, and many will have long-term real returns of less than zero. It is possible that, in the next few decades, we shall see a government bailout of this system that will make the savings and loan crisis of the 1990s look like a trip to Maui. may not be spectacular, but at least the majority of managers delivered performance within a few percentage points of the market"s. Because of the substandard nature of most 401(k)s, the average employee is already starting out 2% to 3% behind the market. He will almost certainly fall even further behind because of the partic.i.p.ants" generalized lack of knowledge of three of the four pillars-investment theory, history, and psychology. Toss in the inevitable luck of the draw, and many will have long-term real returns of less than zero. It is possible that, in the next few decades, we shall see a government bailout of this system that will make the savings and loan crisis of the 1990s look like a trip to Maui.
Jack Bogle Breaks Away From the Pack If Fidelity"s ownership structure is unusual, then Vanguard"s is unique. The four mutual fund examples I provided above are not isolated cases. Within almost any a.s.set cla.s.s you care to name, and compared to almost any other fund company, Vanguard offers the lowest fees, often by a country mile. Why? Having told the stories of Charlie Merrill and Ned Johnson"s Fidelity, the time has now come for the most remarkable saga of all-that of Jack Bogle and the Vanguard Group. For it was Mr. Bogle who finally realized Merrill"s dream of bringing Wall Street to Main Street.
John C. Bogle did not exactly tear up the track in his early years at Princeton. He had a particularly shaky freshman start, but by his senior year had begun to impress his professors with his grasp of the investment industry. The choice for his senior thesis could not have been more fortuitous-"The Economic Role of the Investment Company." (Bogle had his interest piqued by a 1949 article about mutual funds in Fortune Fortune.) Bogle"s thin tome was a snapshot of the nascent mutual fund industry in 1951 and, more importantly, a roadmap for its future. Graduating from Princeton magna c.u.m laude, he set out to make his mark on the investment industry.
Walter Morgan, who worked for one of the few fund companies in existence at the time-Wellington Management Company-decided to hire this brash beginner. Bogle was an ambitious young man and was concerned that the tiny mutual fund industry might not offer a palette broad enough to support his aspirations. He needn"t have worried. For in the process of almost single-handedly creating his vision of what the investment business should should be, he forever raised the public"s expectations of it. be, he forever raised the public"s expectations of it.
Bogle rose rapidly at Wellington and within a decade became Morgan"s heir apparent. Like everyone else, he got caught up in the excitement of the "Go-Go Era" of the mid-1960s and, in its aftermath, became hors de combat hors de combat, fired from what he had begun to think of as "his" company-Wellington.
But Wellington Management had picked the wrong man to fire. Few managers knew the ins and outs of the fund playbook-the Investment Company Act of 1940-as well as Jack Bogle. Among other things, the Act mandated that the fund directorship be separate from that of the companies which provided their advisory service, in this case Wellington Management. Fortuitously, only a few of the fund"s directors worked for the management company. After months of acrimonious debate, the Wellington Fund Fund declared its independence from Wellington declared its independence from Wellington Management Management, and on September 24, 1974, with Bogle at the helm of the new company, Vanguard was born. At a stroke, he became his own man, free to let loose upon an initially unappreciative public his own private vision of the great investment company utopia-The World According to Bogle.
The new company"s first order of business demonstrated Bogle"s revolutionary genius by establishing a unique ownership structure-one never before seen in the investment industry. It involved creating a "service corporation" that ran the funds" affairs-accounting and shareholder transactions-and was owned by the funds themselves. Since the service company-Vanguard-was owned exclusively by the funds, and the funds were owned exclusively by the shareholders, the shareholders were Vanguard"s owners Since the service company-Vanguard-was owned exclusively by the funds, and the funds were owned exclusively by the shareholders, the shareholders were Vanguard"s owners. Vanguard became the first, and only, truly "mutual" fund company-that is, owned by its shareholders. There was, therefore, no incentive to milk the investors, as generally happened in the rest of the investment industry, because the funds" shareholders were also Vanguard"s owners. The only imperative of this system was to keep costs down.
This structure, by the way, exists in a few other areas of commerce, most prominently in "mutual" insurance companies, in which the policyholders also own the company. This ownership structure is disappearing from the insurance industry scene, however, with existing policyholders receiving company stock. TIAA-CREF, the teachers" retirement fund, also offers mutual funds to the general public. While not mutually owned by its shareholders like Vanguard, it functions essentially as a nonprofit and offers fees nearly as low as Vanguard"s.
In 1976 came the first retail index fund. By this time, Bogle had learned of the failure of active fund management from several sources: the study by Michael Jensen we mentioned in Chapter 3 Chapter 3, the writings of famed economist Paul Samuelson and money manager Charles Ellis, and, of course, from his own painful experience at Wellington. (Incidentally, Samuelson"s economics textbook was the source of Bogle"s initial troubles at Princeton. Had he scored a few points lower in that introductory course, he"d have lost his scholarship and been forced out of school. The world would have never heard of the Vanguard Group.) Bogle calculated by hand the average return of the largest mutual funds: 1.5% less than the S&P 500. In his own words, "Voila! Practice confirmed by theory." His new company would provide the investor with the market return, from which would be subtracted the smallest possible expense. Thus did Bogle make available to the public the same type of index fund offered to Wells Fargo"s inst.i.tutional clients a few years before. The expense ratio was fairly small, even for those days-0.46%.
Last to go were sales fees. Realizing that these fees were inconsistent with indexing and keeping costs as low as possible, Bogle made all of his funds "no-load," that is, he eliminated sales fees, which had been as high as 8.5%. In this respect, Bogle was not quite a pioneer; several other firms, including, ironically, Scudder, had previously eliminated the load.
At the time, this series of actions was considered an act of madness. Many thought that he had lost his head and predicted the firm"s rapid demise.
In a remarkable tour de force tour de force, less than two years after leaving Wellington, Bogle had a.s.sembled in one place the three essential tools that would forever change the investment world: a mutual ownership structure, a market index fund, and a fund distribution system free of sales fees.
Although Vanguard did not exactly set the fund business on fire during its first decade, it gradually grew as investors discovered its low fees and solid performance. And once fund sizes began increasing, the process became a self-sustaining virtuous cycle: burgeoning a.s.sets allowed its shareholders the full benefit of increasing economies of scale, reducing expenses, further improving performance, and attracting yet more a.s.sets. By 1983, expenses on Vanguard"s S&P 500 Index Trust fell below 0.30%, and by 1992, below 0.20%.
Interestingly, it was with its bond funds that Vanguard"s advantage first became most clearly visible. There were two main reasons for this. First, the Vanguard 500 Index Trust could not have picked a worse time to debut. During the late 1970s, small stocks greatly outperformed large stocks. Recall Dunn"s Law, which states that the fortunes of indexing a given a.s.set cla.s.s are tied to the fortunes of that a.s.set cla.s.s relative to others. In other words, if large-cap stocks are doing terribly, so too will indexing them. Because of this, Vanguard"s first index fund was in the bottom quarter of all stock funds for its first two full calendar years and did not break into the top quarter (where it has remained, more or less, ever since) for six more years.
Second, as we saw in Figures 3-1 Figures 3-1, 3-2 3-2, and 10-1 10-1, there is a great amount of scatter in the performance of stock funds. Over periods of a year or two, a 0.50% expense advantage is easily lost in the "noise" of year-to-year active stock manager variation. Not so with bonds-particularly government bonds. One portfolio of long Treasury bonds or GMNA (mortgage-backed) bonds behaves almost exactly the same as another. Vanguard"s GNMA fund has a rock-bottom expense of 0.28%, while the compet.i.tion"s average is 1.08%.
In the bond arena, this 0.80% expense gap is an insurmountable advantage-even the Almighty himself is incapable of a.s.sembling a portfolio of GMNAs capable of beating the GNMA market return by 0.80%. Of 36 mortgage bond funds with ten-year track records as of April 2001, the Vanguard GNMA fund ranks first. Among all government bond funds, it is by far the largest-more than twice the size of the runner-up.
Initially, the compet.i.tion was scornful, particularly given the poor early performance of the Vanguard Index Trust 500 Fund. But as Vanguard"s reputation, shareholder satisfaction ratings, and, most importantly, a.s.sets under management grew, it could no longer be ignored. By 1991, Fidelity threw in the towel and started its own low-cost index funds, as did Charles Schwab. As of this writing, there are now more than 300 index funds to choose from, not counting the newer "exchange-traded" index funds, which we"ll discuss shortly.
Of course, not all of the companies offering the new index funds are suffused with Bogle"s sense of mission-fully 20% of index funds carry a sales load of up to 6%, and another 30% carry a 12b-1 annual fee of up to 1% per year for marketing. The most notorious of these is the American Skandia ASAF Bernstein (no relation!) series, which carries both a 6% sales fee and a 1% annual 12b-1 fee. Paying these sorts of expenses to own an index fund boggles the mind and speaks to the moral turpitude of much of the industry.
There are other fund companies besides Vanguard well worth dealing with. TIAA-CREF-the pension plan for university and public school teachers-functions much like Vanguard, with all "profits" cycling back to the funds" shareholders. If you employ a qualified financial advisor, Dimensional Fund Advisors does a superb job of indexing almost any a.s.set cla.s.s you might wish to own at low expense. There are a few for-profit fund companies, like Dodge & c.o.x, T. Rowe Price, and Bridgeway, that are known for their investment discipline, intellectual honesty, and shareholder orientation. If you just can"t make the leap of faith to index investing, these are fine organizations to invest with. Finally, there"s even one load fund company worthy of praise: the American Funds Group. Its low fees and investment discipline are head and shoulders above its load-fund brethren. And if you have $1 million to invest, you can purchase their family of funds without a sales fee.
Thus did Vanguard finally shame most of the other big fund companies into offering inexpensive index funds. The Fidelity Spartan series has fees nearly identical to Vanguard"s, and Charles Schwab"s are not unreasonable, either. But none has offered the breadth of a.s.set cla.s.ses offered by Vanguard. Until last year.
The recent explosion of "exchange-traded funds" (ETFs) has changed the landscape of indexing. ETFs are very similar to mutual funds, except they are traded as stocks, similar to the investment trusts of the 1920s and to today"s closed-end funds. The best known of these vehicles are Spyders, based on the S&P 500, and Cubes that track the Nasdaq 100. (A bit of nomenclature. In this context, the traditional mutual fund is referred to as "open-ended.") There are advantages and disadvantages to ETFs, all relatively minor. The advantages are that they can be run more cheaply than an open-ended mutual fund, since the ETF does not have to service each shareholder as an individual account. Also ETFs, because of the way they maintain their composition, can be slightly more tax efficient than regular mutual funds. They are also priced and traded throughout the day, as opposed to the single end-of-day pricing and trading of a regular fund. On the minus side, like any other stock, you will have to pay a spread and a commission. This can be a real problem with some of the more esoteric ETFs, which are very thinly traded, and thus can have high spreads and even high impact costs at small share amounts. This will dent your return a bit.
My other concern about ETFs is their inst.i.tutional stability. It is highly likely, but not absolutely certain, that Vanguard and Fidelity will still be supporting their fund operations in 20 or 30 years. The same cannot be said for many other ent.i.ties offering ETFs. The concern here is not so much that your a.s.sets will be at risk-the Investment Company Act of 1940 makes that a very unlikely event. Rather, given the corporate restructuring that is endemic in the industry, I would worry the companies may decide that poor-selling ETFs should be dissolved, incurring unwanted capital gains. So I would not hold any of the more obscure ETFs in a taxable portfolio.
But ETFs are extremely promising. The scene is still evolving rapidly and by the time you read this, there will likely have been further dramatic changes in this area. It is now easy to build a balanced global portfolio consisting solely of ETFs. However, at the present time, because of the above considerations, I"d still give the nod to the more traditional open-ended index funds.
CHAPTER 10 SUMMARY.