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Are Mutual Fund Managers Earning their Keep?

Are Mutual Fund Managers Earning their Keep? 
Ron DeLegge, Editor
April 24, 2009

SAN DIEGO (ETFguide.com) – Millions of mutual fund investors have been sold a pipedream and they don’t even know it. Others know it and they simply don’t care. If you own mutual funds, isn’t it time you found out how your funds have really performed versus corresponding index funds and ETFs? 

To that end, Standard & Poor’s has just released its analysis of active mutual fund managers compared to S&P indexes. And the data is a stunning blow to all would-be market beaters.

S&P’s research discovered the majority of active funds in 8 of 9 major stock categories failed to beat corresponding S&P stock indexes. The S&P 500 (NYSEArca: SPY) beat 71.9% of active managers while the S&P MidCap 400 (NYSEArca: MDY) and S&P SmallCap 600 (NYSEArca: IJR) outperformed 79.1% and 85.5% of managers in matching categories. The data was recorded over a five-year period ending in 2008.

“The belief that bear markets favor active management is a myth,” stated the S&P report. The analysis also revealed similar results of bear market underperformance by mutual fund managers during the last downturn from 2000 to 2002.

What does all of this mean?

It means the statistical evidence continues to show that investors would be better off investing in dumb index funds and ETFs than investing with dumb fund managers.

Rewarding Failure
One of the key problems with mutual fund management is their convoluted business practices of rewarding failure. Instead of punishing bad behavior, they reinforce it. For example, in 2008, Mario Gabelli vacuumed in a $46 million paycheck from GAMCO Investors (NYSE: GBL) even though client assets at the firm fell by 33%. Despite the worst economic and market conditions of our generation, Wall Street’s fund executives are still cashing in like a bear market never happened. Mr. Gabelli is a Barron’s roundtable contributor and he presides over funds such as the Gabelli Equity Trust (NYSE: GAB) and the Gabelli Asset Fund (Nasdaq: GABAX).

 “Having a mutual fund management company is like having a toll booth on the George Washington Bridge all for yourself,” is what Marty Whitman, manager of the Third Avenue Value Fund (Nasdaq: TAVFX) told Forbes Magazine. If that’s true, it looks like John Bogle’s “Designing a New Mutual Fund Industry” will have to wait a few more decades. Sorry Jack. In the meantime, all investors should immediately start re-designing their own investment portfolios to avoid getting victimized.

Who’s Protecting Who?
Instead of protecting mutual fund shareholders as they should be, mutual fund titans have resorted to 4th grade techniques, namely, finger pointing. In a recent letter to mutual fund shareholders, the Chairman of Fidelity Investments Edward C. “Ned” Johnson III, gave the financial services industry a severe verbal licking.  

"Although we ended 2008 better than a number of financial firms, it was a year of painful experience for the financial services industry, a period laced with toxic investment waste and the casual use of other people's money by a number of institutions," Johnson said.

What Johnson failed to mention in his criticisms was the most interesting of all.

Did you know that Fidelity’s fund managers more than doubled their ownership stake of floundering bailout kid, Citigroup (NYSE: C) during the fourth quarter of last year? As Citi was sinking, so were Fidelity’s equity mutual funds. In 2008, 64 percent of the firm’s stock funds were beaten by its peers. I wonder if this is this the “toxic investment waste” Fidelity’s Chairman was referring to.

In contrast, index funds and ETFs have been “protecting” their shareholders during this vicious bear market. How? Quite simply, by not doubling and tripling up on dead-beat stocks like Citigroup. Now that Citi’s market cap has collapsed, so has its rotten-apple influence on the performance of major stock benchmarks that contain it. By design, stocks with the lowest market capitalizations have the least amount of influence on the performance of an index. 

The Performance Chasing Mafia (PCM)
There are others who claim they can find mutual funds that do beat the market. I classify them as official members of the performance chasing mafia or “PCM” for short. They remain utterly defiant (and aloof) about the relevant statistical facts, because they know better.

Take for example, Adam Bold, founder and chief investment officer of The Mutual Fund Store, a chain of 70 fee-only financial advisers. He recently told Bloomberg, “I’m a believer that by indexing, you’re accepting mediocrity. There are a limited number of people who have shown an ability to consistently beat the market year after year.” Earth to Adam! Earth to Adam!

The problem, which Mr. Bold doesn’t address, is that it’s next to impossible to accurately pre-identify top performing fund managers before they become top performing fund managers. That leaves people like Bold with one choice: To chase historical performance. Investors almost never get what they bargained for and performance chasing advisors get lots of fees. Nevertheless, Bold has made himself a very successful Wall Street career in helping people to identify yesterday’s winners, as his $4 billion monstrosity illustrates.

Finding Better Alternatives
Index ETFs are the solution to avoiding underperforming mutual funds. If you don’t want to be limited to ETFs that follow S&P stock indexes, there are other excellent choices to consider.

For example, Vanguard’s ETFs follow MSCI constructed indexes, which generally tend to be broader and more diversified because they own more securities. See the Vanguard Large Cap ETF (NYSEArca: VV), the Vanguard MidCap ETF (NYSEArca: VO), and the Vanguard SmallCap ETF (NYSEArca: VB). All of these Vanguard ETFs charge rock bottom annual expenses that range from 0.07% to 0.13%.

If you need ideas on how to build a successful all-ETF portfolio, check out ETFguide’s Ready-to-Go ETF Portfolios. Our ETF Portfolios just finished their third straight year of outperforming major benchmarks like the S&P 500 and MSCI EAFE (NYSEArca: EFA) stock index. Which ETFs can help you reach your investment goals? Take the time to learn more.

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