Carlson critiques funds: no-load stocks vs. no-load mutual funds

Black Enterprise, Oct, 1995 by Charles B. Carlson

THE FOLLOWING IS selectively excerpted from Charles R Carlson's new book, No-Load Stocks: How to Buy Your First Share and Every Share Directly from the Company--with No Broker's Fee. Carlson, a certified financial analyst is also the editor of Dow Theory Forecasts, a trade newsletter. In the third chapter, Carlson debunks some of the myths surrounding mutualfund investing.

The mutual-fund industry has done a masterful job at selling no-load funds as the only investment that makes sense for small investors. However, what the fund industry doesn't tell you is that mutual funds have their own imperfections that need to be considered by investors. Indeed, the attraction of no-load mutual funds--often at the expense of ownership of individual stocks--may not be all it's cracked up to be. (No-load stocks and mutual funds can be bought directly from some companies, allowing you to bypass a broker and avoiding the fees they charge.

MYTH: MUTUAL FUNDS ARE SAFE INVESTMENTS

Contrary to what many investors believe, mutual funds, including money-market mutual funds, are not federally insured investments. Even mutual funds sold by banks are not federally insured, although a study by the American Association of Retired Persons should that less than 20% of those surveyed understood that mutual funds bought at a bank are not federally insured. And if you use the word safe to mean that mutual funds are immune to sharp downturns, you're wrong as well. Just ask holders of the Steadman Oceanographic Fund, who saw their investment decline 62% for the 10-year period through 1993. Or the holders of the DFA Japanese Small Company Fund, who saw the value of their holdings drop nearly 17% in the five-year period through 1993. Or the Frontier Equity Fund, which posted a nearly 25% decline in 1993. Remember that mutual funds are only as safe as the securities in which they are invested.

From a No-Load Stock (NLS) Perspective. Are mutual funds safer than no-load stocks? I won't attempt to argue that diversification doesn't matter in limiting downside risk, and diversification is easier to achieve with no-load mutual funds than no-load stocks. Still, investors who choose no-load mutual funds over a portfolio of no-load stocks or stocks in general may be surprised to see how unsafe these funds are during declining markets.

MYTH: I CAN EXPECT ABOVE-AVERAGE PERFORMANCE

You can expect above-average performance, but you probably won't get it. In any given year, it's not unusual for at least two-thirds of all mutual funds to underperform the market as measured by Standard & Poor's (S&P) 500. For the 10-year period ending 1993, only funds specializing in international, financial-services, and health-care equities outperformed the S&P 500. General equity funds in that period posted an average gain, including reinvested dividends, of 234.6% versus the return on the S&P 500 of 301.4%

Several factors account for the lackluster performance of most funds. First, many academics argue that the market is so efficient--in other words, stock prices reflect all that is known about a stock and discount information so quickly that finding mispriced stocks is very difficult--that it is extremely difficult to outperform the market on a consistent basis. Many practitioners in the investment field hold that markets are not as efficient as academics believe. Still, you probably won't find too many fund managers who won't acknowledge the difficulty in beating the market.

But even if you believe that it's possible to beat the market regularly, how many mutual-fund managers have the skill to do so? Very few. And the number of mutual-fund managers who truly add value is being spread thinner over an always increasing number of mutual-fund offerings. Indeed, there are now more than 5,000 mutual funds. Are all of these funds being managed by fund managers who add value? Of course not. Furthermore, performance may be even bleaker over the next decade if the financial markets turn more difficult. After all, it wasn't too hard to show double-digit gains during the last decade when stocks in general were rising at such a rapid rate. However, in an environment where market returns are more in line with historical averages of roughly 10% per year for stocks, the disparities between the few effective fund managers and the huge number of mediocre ones will be even more evident.

Also affecting mutual fund performance is that, in some instances, a mutual fund may have little incentive to go for above-average performance. For example, a fund that accumulates, say, $2 billion in assets may have much more of an incentive to maintain the status quo by focusing on conservative investments. That's because, with $2 billion in assets, fees to the mutual fund could be anywhere from $20 to $40 million every year, even if the fund doesn't make a dime for it's shareholders. Thus, preservation of capital rather than aggressive asset appreciation may be the primary objective of the fund manager.

One final factor causing subpar mutual fund returns has been the huge amounts of money flowing into funds in recent years. In many cases, such huge inflows have created problems for fund managers, who are pressured to put these funds to work in stocks. However, especially during periods when stocks are high, huge inflows may force fund managers to abandon investment strategies that were successful. when the mutual fund was small or to invest in stocks that may be overpriced and not offering the best upside potential. Some funds have closed their doors to new participants when they perceived fund assets were overwhelming the fund manager's strategy, but the temptation to take in more money because of the annual management fee has caused a number of mutual funds with stellar track records to join the ranks of mediocre performers. Bottom line: Keep your expectations in check when investing in mutual funds. That way you won't be too disappointed when your fund comes up short.