Thanks to Wall Street's Marketing Machine, most individual investors continue to invest their own capital in mutual funds.
Mutual funds, for all of the foibles, remain the de facto Main Street investment vehicle. But why?
For one, Wall Street spends billions per year touting the funds. Then, Wall Street's minions, the 50k financial advisors working for the major brokerages, also use them. Not for themselves. But for their clients. They require less effort. Less expertise. Utilizing mutual funds, an advisor can play more golf, do more marketing, and still get paid.
I'm not saying that all mutual funds are terrible. Only the ninety-five percent utilized by most investors. That is, the ones you use.
Actively managed mutual funds attempt to beat the market by purchasing a portfolio of stocks that will outperform the benchmarks. These bright, capable investment professionals usually have the best of intentions. Yet, their task is difficult.
Most mutual funds charge fees and expenses in the one to two percent range. These fees are charged based upon the assets under management. The more assets, the more fees, the more money is made. Accordingly, the incentive is on gathering assets. Not performance.
As mutual funds grow in size, they become less flexible in terms of the potential investments they can make. The investment policy of most funds forces them to avoid small, conceivably risky companies in order to invest in large, blue chips with huge amounts of liquidity (shares traded).
Therein lies the rub.
Most of these funds end up owning the same large, easily researched blue chip stocks. These blue chip stocks do not typically provide outsized returns to the average investor. In fact, most blue chip banks, consumer products and technology companies consider it a point of pride if they've managed to keep pace with the benchmarks. Once the fund's fees have been subtracted (not to mention those of the advisor), any outperformance is negated.
Next, consider that most mutual funds own between seventy five to two hundred stocks. For the quantitatively gifted, it is difficult to assess the proper valuation of ten companies. One hundred or more? Well, you need more than an abacus.
Even with ability to accurately value many companies, the idea that the market will price a handful of those a fund manager is following at substantial discounts to intrinsic value is highly unlikely.
Further, having so many small positions in so many companies ends up detracting from the value of the occasional home run. A fifty percent gain in a position that represents a half of one percent of the portfolio ends up doing little for your financial prospects.
Another problem? Keep in mind that fund managers are essentially boring. Not saying they make bad company. But, that their investment policies make them predictable and monotonous. Yet the market is anything but.
That is to say that fund managers pay little mind to events that often create alpha, or market outperformance. Like stock buybacks. Corporate spin offs. Restructurings. Bankruptcy turnarounds. Negative headlines.
These are the situations that bring markets to misprice a company. These are the situations that create discernible opportunities.
In other words, most mutual funds are buying two hundred stocks because they feel these companies are positioned to do well over the long run. So, when the market goes up, these companies follow. And when the market goes down, these companies do the same.
Require anecdotal evidence?
Consider Chemed Corporation. In May, the stock went from $82 to $63.90 when the Justice Department announced an investigation into the filing of false Medicare claims. Not the company's first rodeo. Hospice and long-term care facilities, like Chemed's, face such occasional allegations.
We know that Chemed's healthcare and plumbing businesses generate lots of cash. We also appreciated the company's low price-earnings-to-growth ratio, which represented an attractive current price versus Chemed's future earnings.
So, we purchased some Chemed. Shares rose to $75, and currently sit at $72.
There is yet another problem endemic to mutual funds.
Smaller, more esoteric companies are more likely to be valued at substantial discounts to their intrinsic values. There are many more small than large publicly traded companies. They are lesser known. Not as widely followed. So, there exists much more opportunities for mispricing.
Moreover, smaller companies, when valued appropriately, are more likely to provide the outsized gains fancied by most investors.
Unfortunately, most actively managed mutual funds cannot buy them.
Many fund regulations require that no fund can own more than 10 percent of the shares of any company. Smaller companies have smaller floats (amounts of shares outstanding).
Nor can any position typically represent more than five percent of a fund's portfolio. Leaving most funds unable to invest in companies with market caps below a certain level, and severely limiting their abilities to find small, exciting opportunities.
Most funds cannot even invest in stocks trading at less than five dollars per share. Talk about a handicap.
All of which prevents funds from taking large, concentrated positions that would potentially reward the rigorous analytical research of lesser know yet altogether viable companies.
Remember, even Microsoft once traded for less than a dollar.
If the stated goal of most mutual funds is to outperform their respective benchmarks, then the best approach would be to:
1. Consider investments in the thousands of lesser-analyzed, smaller-capitalization stocks that exist in today's markets...
2. Take fewer, more concentrated positions after rigorous analytical efforts have translated to strong investment convictions...
3. Lower those often cumbersome internal expense ratios to a point where the fund has a chance to outperform with more regularity...
4. Quit rewarding mediocre fund managers with billions of dollars in new assets.
From 2000 to 2009, the S&P 500 averaged a negative one-percent annual return. That same decade, the average investor lost 11 percent per year. Poor decisions. Poor timing. High fees. Bad funds. Not to mention the hundreds of biases and psychological barriers most investors can never overcome.
Today, the onus is increasingly on individual investors to achieve some semblance of financial independence. Thus, the last thing investors need are lemons parading as Ferraris. That is, well-marketed investments offer mediocre returns. Yet, that is what most actively managed funds provide.
Hyde Park Wealth Management's Core+Alpha methodology endeavors to find those yet-to-be-developed areas of the market. Once established, our portfolio managers buy land before the developers, surveyors, bulldozers and occupants arrive in mass.
The method employed by most mutual funds is more akin to flipping homes in midtown Manhattan. Loads of work. Low margins. Intense competition. Low returns.
Yet, fund flows reveal that Main Street continues its abusive love affair with the mutual fund industry.
The average mousetraps, billion-dollar advertising campaigns, and legions of salesmen posing as advisors have kept the mutual fund industry fat and happy. Even as over 70 percent of actively managed funds do not outperform the S&P 500 index each decade.
To outperform the market, one must invest differently than does the market. But, when fund managers can make king's ransoms by surviving, why build a better mousetrap?
Especially when the mice are willing to settle for so little cheese.