How the Mutual Fund Industry Makes Money

Do you ever wonder why mutual funds managers get to drive around in nice cars?

Recall that mutual funds are professionally managed investments that pool money from many investors and invest it in stocks, bonds, short-term money market instruments, or other securities.

When the naïve individual goes toe to toe with the sophisticated investor, it’s like watching me on a tricycle trying to beat Lance Armstrong on his bike. Mutual fund investors’ portfolios consistently under-perform because the balance of power in the investment management world tilts in favor of the profit-seeking investment manager. After all, how do you think they afford their lavish lifestyles? But is it our responsibility to keep them in their fancy clothes, cars and homes?

Should you bother trying to protect yourself from all this by investing with organizations that reduce or eliminate this conflict? Not-for-profit organizations like Vanguard or TIAA-CREF focus solely on fulfilling their responsibility to the individual investor. And since they are not-for-profit, they are not driven to maximize profit at the expense of their investors. This leads to lower costs to investors. But it appears that many individual investors have been duped into thinking that actively-managed for-profit mutual funds are the only game in town.

With the exception of not-for-profit mutual fund companies, the rest of the industry is simply set up to extract money from you leaving nothing but underperforming Investment portfolios. Here’s some of the ways they do it:

1. Persistently high fees

There are fees that you see and fees that you don’t see. Expense ratios for active management in particular are sometimes in excess of 3% per year. Some funds impose so-called “Rule 12b-1” distribution fees (these are fees for marketing) of up to 1% annually on their shareholders. And if you’re not using a discount broker you may also have to pay sales loads of up to 8.5% on certain classes of funds. No joke.

There are a lot of hands in your pocket. You’re not alone. Brokers, mutual fund managers, analysts, operations and marketing teams all want to get paid and also earn money for their fund company owners. Have you seen the cars these guys drive around in? I bet they're not as clunky as yours…

2.Taxes

You are probably paying too many unnecessary capital gains taxes. Turnover is how much a portfolio manager buys and sells the securities in a mutual fund. The relatively high turnover for actively managed funds is costly to you, not only in terms of transaction costs, but also in creating short-term taxable gains. And if that’s not bad enough, the selling decisions of other investors can trigger tax liabilities for the fund shareholders left behind. That means you get to pay more unnecessary taxes because your portfolio manager feels the need to trade.

Portfolio managers like to do a lot of this, in fact, securities are held for just about 12 months industry wide. According to Morningstar, the average fund has an 89% turnover ratio. That means it trades (turns over) 89% of its holdings. What that means for you is taxes, and a lot of them. What’s more, you don’t control whether you have to pay them or not, since you can’t tell the portfolio manager what to do.

Let’s not forget that countless studies have shown that mutual fund managers rarely beat the performance of the market over the long-term

I don’t care how smart they are or what schools they went to. Your fund manager is not going to beat the market consistently, long-term. But he does have an enormous marketing machine behind him that will make you believe he does. He might also have a few “good” years, in which case greed takes over the mind of investors and they buy a fund at the top. Forget bargain hunting. Like a baby lulled to sleep, fund investors are lulled into a happy state of bliss. They can always show their friends how well they’re doing with fancy brochures even though the reality is quite different. Some lucky ones could even say that they invested with Bernie Madoff. Think of the bragging rights.

Investing is a zero-sum game. If someone profits, someone loses. There is NO win-win. There have been far too many serious studies showing that actively managed mutual funds (or rather the humans who manage them) will always underperform the market and index funds.

But there are always the few of us who think that we are smarter than the rest and know how to spot a good manager. Well I’m here to tell you forget it. I’ve seen some of the smartest, most experienced analysts with access to enormous amounts of data who can’t do it.

Should you always pay more for a BAD product? Of course not. Yet Index Funds don’t get the marketing and publicity that actively-managed funds do. Then again, no one is going to make any money off you if you invest in those.

For more details on mutual fund fees read my blog What They Won't Tell You about the Fine Print. Enjoy.