Financial Scandal

Susan Lee Miller, president of Index Investor, Inc., recently wrote an editorial on the financial scandal that is the modern mutual fund industry. She wrote as follows:

“Amid all the talk and reporting over the past year about Enron, Worldcom, and Wall Street analysts, one of the biggest financial scandals has gone almost unnoticed. By encouraging the use of actively managed mutual funds instead of index investments, the financial services industry is costing investors almost forty billion dollars each year in the United States alone. On a global scale, the cost is even higher.”

Elsewhere on this web site, we provide the Evidence regarding the failure of mutual funds to justify their high Costs, and demonstrate the superiority of low-cost index funds to achieve investment goals. Ms. Miller, however, puts a dollar amount on these total lost investment dollars, forty billion a year, dollars misspent by mutual fund managers in their failed attempt to add value to customers’ accounts in excess of what those customers could obtain through investment in comparable index funds. Dollars lost that could otherwise provide funds for education or an enhanced retirement. (See Investment Illusion and Fooled By Randomness for a full discussion of the mechanics of this poor investment decision-making process.)

In this spirit of discourse on the “modern mutual fund financial scandal”, a devastating critique of the modern mutual fund industry and its consequences on the financial lives of millions of investors, was recently provided by John C. Bogle.

On March 12, 2003, Mr. Bogle, a pioneer in the development of index fund investing and a great investment consumer activist, spoke to Congress about mutual fund costs and governance structure. Mr. Bogle testified in front of the U.S. House of Representatives Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises of the Committee of Financial Services (hereinafter, the “Subcommittee”).

The Subcommittee was considering changes to legislation regulating the mutual fund industry.

The wily veteran of over 50 years in the mutual fund industry came armed with facts. In regards to mutual fund cost issues, the facts presented by Mr. Bogle mirror the kind of studies reviewed in Evidence and Costs elsewhere on this web site. Following are some of Mr. Bogle’s facts presented before the Subcommittee:

“A study of stock fund returns during the decade ended June 30, 2001, for example, showed that the low-cost quartile of funds earned an average net return of 14.5% per year, while the average high-cost fund earned an average of 12.3%, a 2.2% gap that was even larger than the 1.2% expense ratio gap between the two groups (0.64% vs. 1.85%).” (Emphasis Added By IFE).

“An additional statistical test showed that this clear linkage between cost and return prevailed even more strongly when fund returns were adjusted for risk. The higher-cost funds were clearly assuming higher risks, and the gap in favor of the low-cost quartile rose to 3.0% per year.” (Emphasis Added By IFE).

Mr. Bogle then paused (in his critique of mutual fund cost structure) to discuss the changes he has witnessed in the modern mutual fund industry compared to the mutual fund industry of old. Anticipating some of his later recommendations on legislative requirements on mutual fund governance, Mr. Bogle said:

“The mutual fund industry that I read about in Fortune magazine in 1949 is almost unrecognizable today. Over and over again, the article spoke of “trustee,” “trusteeship,” “the investment trust industry,” words that we rarely see today. Over the half-century-plus that followed, in my considered judgment, the fund industry has moved from what was largely a business of stewardship to a business of salesmanship, a shifting of our primary focus from the management of assets investors have entrusted to our care to the marketing of our wares so as to build the asset base we manage.”

(See Investment Illusion and Where Are The Customers’ Yachts elsewhere on this web site for a fuller discussion of, respectively, the mechanisms of investor entrapment utilized by this modern mutual fund industry and the (index fund) consumer revolution underway to counteract this trend.)

Mr. Bogle then went on in his presentation to cite nine specific “changes” between the new and the old mutual fund industry including the following:

“Our shareholders, on average, now hold their fund shares for much shorter periods—just over two years, compared to 16 years in the 1950s and 1960s.

“As the creation of new funds (often speculative funds, formed to capitalize on the market fads of the day) has soared, the fund failure rate has risen to an all-time high. (At present rates, fully one-half of all of today’s funds won’t be around a decade hence.)”

“The costs of fund ownership have also soared, with expense ratios of the largest funds rising 134%—from 0.64% in 1951 to 1.50% in 2002.”

“Once a profession practiced almost entirely by privately-held enterprises, the management of mutual funds has largely become the business of giant financial conglomerates, which own 36 of the 50 largest fund managers.”

Mr. Bogle then asks if the changes have “been of service to fund shareholders?” Mr. Bogle answers, of course, with facts, as follows:

“Largely because of far higher costs, the returns earned by the average mutual fund in the “new” industry has lagged the returns of the stock market itself (measured here by the Standard & Poor’s 500 Stock Index) by a substantially larger amount than the lag during the era of the “old” industry. Specifically, the performance lag has nearly doubled, from 1.6 percentage points per year to 3.1 percentage points per year.” (Emphasis added by IFE).

“As it turns out, the major reason that the return of the average equity fund lagged the stock market by 3.1% is the costs that investors’ funds incur—the management fees, the operating expenses, the-out-of-pocket fees, the portfolio transaction costs, the sales charges, and the ‘opportunity cost’ represented by the significant cash positions typically held by funds.”

“The substantial increase in expense ratios, combined with the staggering growth of fund assets, means that the revenues generated to fund managers rose almost exponentially. Specifically, these 25 original funds were operated at an average cost of just $520 thousand in 1951; in 2002 the average cost of the 20 remaining funds came to $44 million, a 85-fold increase dwarfing the 57-fold increase in assets.”

Mr. Bogle then sums up his presentation on mutual fund cost data as follows:

“Investors are largely unaware of the high level of mutual fund costs, and even less aware of the powerful effect of these costs on the compounding of their returns over the long-term. I believe that we urgently need new SEC rules that require greater cost disclosure.”

Mr. Bogle concluded his presentation to the Subcommittee with recommendations as to enhanced “costs” disclosure requirements and (to foster serious fee negotiations between mutual funds and their advisers) as to changes in governance structure of mutual funds.

Summary

The mutual fund “financial scandal” is different from the other scandals that Ms. Miller cited in the first paragraph of this web page. While we will wait to see what the courts will say about some of the actions taken by major players at Enron, Worldcom and the like, it would not be surprising to see some of these folks in jail. Such is not the case in the mutual fund financial scandal.

The scandal in the mutual fund industry is, however, in some respects, worse. First of all, its worse because of the magnitude of the mutual fund scandal, 40 billion a year in the U.S. alone, according to Ms. Miller.

Then, it is the number of people affected. Investment in mutual funds is undertaken by millions of American investors who depend on returns from investment to fund college for the kids and retirement for themselves.

But, in the final analysis, what is most disturbing about the mutual fund financial scandal is precisely that it’s “all legal”. No one’s going to jail over the kinds of “distortions” we discuss at Investment Illusion elsewhere on this web site. Inducing investors into “hoping” that they can get higher returns by (unjustifiably) trusting in the investment acumen of smooth-looking, smooth-operating (and expensive) mutual fund giants (or the brokers that hype them) is no crime. Will we see Congress enact, as Mr. Bogle recommends, better disclosure and mutual fund governance regulations to give the average investor a better chance? Probably not. The industry has humungous amounts of money and lobbyists at their beck and call.

But, YOU, THE INFORMED INVESTOR, can make the change. YOU can follow the Evidence, examine the true Costs, and better comprehend the mechanism of Investment Illusion. And YOU can explain it to a friend or two. And they can explain it to a friend or two.