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Mark's Market Blog

Part VIII: Mutual Funds

By Mark Lawrence

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There are people who manage large groups of investments, called "funds." You can buy shares in these funds, and now you have instant diversification. Is this a good idea? There are three major ways to buy a large basket of investments, which are called mutual funds, index funds, and ETFs.

A Mutual Fund is a large block of money that is managed by professionals. These people make daily decisions on which investments to buy, which to hold, and which to sell. You give your money to these professionals and they manage it for you. Sounds pretty neat, right? Well, there are some drawbacks. First, the professionals don't work for free. They take some of the money each year for themselves - after all, they have to eat too, right? Typically a mutual fund will have an overhead of 2% - 4% per year. This means the manager has to be better than the S&P 500 by 2% to 4% per year just so that you break even. In addition, if you buy a mutual fund from a large stock broker or money manager, you will typically pay the stock broker 3% - 4% of your money for the "privilege" of buying into the fund. This is very curious, as you can most likely buy the mutual fund on the stock market yourself, using E-Trade or AmeriTrade, and the entire transaction will cost you about $15. When listed on a stock exchange, mutual funds have symbols that end in "X." For example, Fidelity's Magellan fund is FMAGX and Vanguard's Index 500 fund is VFINX.

Now the interesting question is, do these professionals actually out perform the S&P 500? Do they actually make your money grow due to their intrinsic cleverness, or do they simply sit in their boat and ride the rising tide of the stock market? If the market goes up generally so does their fund. It turns out that about 80% of all mutual funds do worse than the S&P 500. And remember, we're not trying to do just as well as the S&P, we need to do about 3% better to pay for the MBAs. So, to make a mutual fund worth it, you have to be clever enough to pick one in about the upper 10%. Then, if you bought this through a large broker or money manager, you also have to not only beat the S&P 500 by 3%, you also have to beat it by at another 3.5% or so to earn back your sales commission. Good luck.

Suppose you have a bunch of money in a mutual fund and you want some back. What happens? Mutual funds settle up at the end of the day. If you see the market coming apart and you want to sell right now, this instant, too bad. You don't get to sell until the end of the day, and no matter when the money managers may have sold their stocks, you will be paid based on the lowest price of the day. If you give them money, it's just the opposite: you'll pay the highest price of the day. Since most stocks move about 1% a day or so, this is another 1% of your money that evaporates going in, and yet another 1% of your money that evaporates coming out. Perhaps you're thinking, "1%? That's not so bad, is it?" Realtors charge 6% to spend 4 months selling your house. These guys want a 3.5% sales commission on the day you buy, another 1% profit on the buy in day, roughly 3% of your money each year for holding on to it for you, and another 1% profit on your money when you take it out. Nice deal. For them, anyway.

What can you do about this? If you're determined to own some mutual funds, perhaps you truly think there are managers out there that are this good. In this case I suggest you decide on your own which funds to buy. Get yourself an account a E-Trade or Ameritrade, and buy the shares yourself for $15 per transaction. When you open your on-line account, you may specify that the account should be an IRA or 401K, so you can even manage your own retirement money like this. Trust me, the nicely dressed man at the brokerage house is a salesman, not an investment expert. If he was an investment expert, he'd be working at one of the funds making $250,000 per year plus bonus, instead of working at the brokerage house making $30,000 per year plus commission.

The nice salesman will have a lot of graphs and charts to show you about how his fund has out performed pretty much anything you can imagine. Here's a little homework for you. Go to Yahoo Finance or MoneyCentral.MSN and chart the DOW, S&P 500, and NASDAQ over several periods, 5 days, 30 days, 60 days, 1 year, 2 years, 3 years, 5 years. You'll see some really quite remarkable things. The first thing you'll notice is that which index wins depends very strongly on when you start the graph. Today, the NASDAQ wins on the 3 year graph, but loses on every other graph. Trust me, the nicely dressed salesman won't be showing you the graphs where his stuff loses. Heck, he hasn't even seen those graphs. He's got a beautiful color sales packet that someone else made up for him. He knows no more about how to invest money than a used car salesman knows about designing computer controlled fuel injection and valve train systems for 400 horse power low emissions Corvettes.

Are there money managers who consistently out perform the stock market? Yes. Warren Buffet is an excellent example. From 1965 to 2004, the S&P 500 has averaged a gain of 10.4% per year. That means if you had simply put $1,000 into a S&P 500 fund in 1965, at the end of 2004 you would have had $5.3M. In those 40 years, the S&P 500 lost value in 9 years, and gained value in 31 years. However, Warren Buffet's holding company, Berkshire Hathaway, averaged 21.9% per year over the same period. If you had bought $1,000 worth of Berkshire Hathaway stock in 1965, at the end of 2004 you would have had $287M. Over the same 40 years, Mr. Buffet gained value in all but one, and out performed the S&P 500 in all but 5.

We must be careful about thinking this is easy, however. The S&P 500 tells us the average stock market gain. If there are people who are doing better than average, there must also be people who are doing worse than average. You want to be careful not to be one of the 'worse than average' crowd. Remember, 80% of all mutual funds do worse than average, and that's not including the money they take from you in sales commissions, operating costs, and entry and exit profits. In my opinion it's fair to call Berkshire Hathaway Corporation a mutual fund, except that to my knowledge there is no other mutual fund that has had anywhere near the performance level of Berkshire Hathaway. At the time of this writing, Berkshire Hathaway shares are selling for $85,000 each.

Bottom line: just in case you haven't picked up on it by now, I'm not a big fan of actively managed Mutual Funds. Except for Berkshire Hathaway. If you simply must buy into a mutual fund, buy the shares directly online and don't pay the 3.5% sales commission. If you don't know which mutual fund you want to buy, you don't belong in this market any more than a 16 year old with a checkbook should be out shopping for Porsches and Ferraris. If you want to research mutual funds, go to MorningStar.com or MoneyCentral.MSN.


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