Is There no Future for Actively Managed Mutual Funds?

August 2, 2004

Maybe the Fund Managers Deserve the Sex Pistols

John Mauldin writes a weekly letter, to which I subscribe.  It always contains good stuff, and it is free.  The subject varies a lot, but it is focused on finance and investment.  He wrote, for example, an excellent article on the Velocity of Money, which I actually understood.  

Now the situation with actively managed mutual funds, as I see it, is rather simple.  I know of no manager who is good in both bull and bear markets.  There are some bear market funds that do well when the market is going down, and a lot of bull market funds which do very well when the market is going up.  With the exception of Hussman's fund, HSGFX, there is no fund that does well in both bull and bear markets.  And Hussman underperforms, so far, in a bull market, even though he does make money.

From this it follows that the best way to make good money in actively managed mutual funds is to trade funds actively.  That means that you time the market.  An alternative is to pick come good bull market funds and to hedge with funds that go short during the periods of market decline.  This keeps you from losing money during market declines, but it generally does not give you as good profits as you would get if you just sold the long funds and held the short ones.

Unfortunately, the fund companies have used the recent market timing scandals to crack down and ban people who trade their funds, even when they hold the funds for several months.  There is always an elastic clause in the prospectus which essentially says that anybody can be banned for anything that they call market timing.  And there is never a definition of market timing.  So if you ever sell, they can ban you for market timing.

The point is that if the funds are not going to time the market, then it is right to expect that people will time the funds.  After all, if I know when a fund is going down and deserves to be sold, why does not the fund manager know that it is time to lighten up on some positions and hedge by selling some futures?

Now I am not going to enter the market timing debate at all.  Mathematically, there is something called a disproof by counterexample, whereby when somebody proposes a theorem, such as There is no way to time the market, all that is required to refute the theorem is to provide a single counter-example, such as TimingCube.  It can be argued that a timing system will fail if everybody uses it.  However there is little chance of that - after all there are large number of people telling the gullible public every day that they cannot time the market.  In addition there is a huge amount of lethargy out there that keeps many individual investors from doing anything at all.  During the bear market of 2001-2002, I read articles about people who simply did not open their 401K statements because they did not want to hear the bad news.  That is the Ostrich Method of Investing, and how many rich ostriches do you know?  The last ostrich I saw was part of a burger at Fuddruckers.

At any rate, John Mauldin's current article is entitled The Endgame For Mutual Funds.  Here is the link.  It is worthwhile to subscribe.  The following is quoted from John Mauldin's letter, but it is written by Doug Fabian:

The question now is, why are mutual funds no longer the place to be? What's different now? Why are funds no longer the darlings of the investment world? Let's take a look at a few of the answers.

Scandals: A funny thing happened about 10 months ago. The public caught wind of the secret after-hours deals available only to favored mutual fund investors that cheated long-term shareholders out of profits. "The world changed on Sept. 3, 2003," said Jay Baris, an attorney who works with the mutual fund industry in a recent Wall Street Journal article. He was speaking of the day New York Attorney General Eliot Spitzer unveiled his investigation into improper mutual fund share trading.

Since news of the fund scandal broke, investors have been questioning the trading practices of many of the most prominent mutual fund companies. They've seen many of their favorite fund companies come under attack and be fined and reprimanded by the SEC for improper trading practices. Until the scandal no one really realized that their personal net worth was being negatively impacted by the behind-the-scenes privileges of a few big players that the fund companies were eager to please at individual investor expense. The scandal got people to question what the fund companies were doing in their name. During this period of questioning people began to look at what they were getting for their money. Over the past five years, investors realized what they were getting wasn't very much at all.

Underperformance: A great number of investors have come to realize that although their portfolios haven't made a great deal of money over the past five or so years, the fees they have consistently paid for the privilege of that underperformance have been omnipresent. We'll get to those outrageous fees in a moment, but let's first stick with underperformance.

It is my contention that the mutual fund industry as a whole does a terrible job of managing money in a bear market. One reason for this is obvious. The fund companies want you to buy and hold their funds, and therefore they won't ever tell you to sell! Think about it, when was the last time you heard of a mutual fund company advocating the sale of one of their funds because the market was just not the place to be? I can't recall ever hearing that. Now there may be a few talented brokers out there who will try to get you to rotate from one market sector to another given conditions in a specific market segment, but brokerages and fund companies don't want you to sell. They want you to continue to blindly pump your dollars into their company so that they can grow their assets. Most of the time, growing your assets is not their first concern. And of course, the last thing they want is to lose your assets via a sale of one of their funds.

The letter goes on to recommend Exchange Traded Funds (ETFs), which certainly can be timed, since they trade like stocks.  Now this is fine, although I see the problem that many of these ETFs are so thinly traded that you will have problems getting good fills on your order.  The same may be said for Closed End Funds, which are actively managed mutual funds that trade like stocks.  I hope that ETFs will be more actively traded, and in particular I hope that it will become easier to short them.  The other alternative, of course, is the Rydex and ProFunds.  These can be traded at will, although if you are at Waterhouse, they charge an absurdly high fee when you do so.  Stay away from Waterhouse, in any case.

As a side note, somebody posted over at the Motley Fool Message Boards read the article and thought it was about EFT - Electronic Fund Transfer.

he wrote about mutual funds outliving their usefulness because of management fees. He spoke to a friend of his Doug Fabian, Editor, Successful Investing, who then wrote an article about electronic fund transfers.

That level of reading comprehension is truly amazing.

At any rate, I have lost a little money this year because I was hesitant to pull the trigger and sell some funds.  I was afraid that the managers would ban me from ever holding the fund again.  Not only that, places like Brown and Waterhouse will actually ban you from all mutual fund trading if you are banned from several mutual funds.  The Brokerages are in league with the fund managers, and neither want you to pursue strategies that will make you money.  I have nothing but contempt for Brown and Waterhouse, just to give a couple of examples.  I am not sure that the others are any better.

My friend, Dave Serbin, is still trading funds, and has a number of funds that he can trade profitably. See his Web site coming soon (7/12/2007).

John Mauldin thinks that eventually mutual funds will be replaced by hedge funds and ETFs.  That would be fine with me, and certainly the industry deserves punishment.  However, John mis-underestimates (to use a popular term) the gullibility of the public.  Remember:  there is a sucker born every minute.  There will always be people who just buy and hold.  It just does not have to be you or me.

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