Wednesday, February 27, 2008

The truth about mutual funds - aka "I am an idiot", and more truth on the stock market

"The February 1999 issue of SmartMoney Magazine saw fit to phrase the question on the minds of 1998's mutual fund investors in these words:
"How could the market be up 22% in 1998 and my returns be only half that?"
"Why, you ask, do all my mutual funds suck?""

Why indeed?
Perhaps start with reading my take on the global stock market, which cuts through the bullshit and tells you how the global marketplace really operates from an individual with %10,000 to invest thru institutional investors, who have a few billion to play around with.

It is a long post and might blog your mind - perhaps just read this current post, analyze it, take action to get rich(er) and to stop losing money to swindlers, and then come back to my take on the global stock market.

Let me begin that I... used to be a complete idiot.
I invested my money in mutual funds, without doing much research, crossing my fingers and hoping for the best. I also was a (self made) stock trader, doing diligent research on stocks, buying and selling weekly, wasting valuable chunk of my life trying to find that pot of gold at the end of the stock market rainbow.

I, however, woke up and told the modern snake oil salesmen in no uncertain terms to, frankly, fuck off.

And now so can you.

First things first. You need to realize that the mutual fund industry is just that - an industry, a business. They are just like any corporation trying to sell you product - in this case, an actively managed mutual fund. A product just like any other. They are in it to make a profit - off of YOU.

Definition time. A managed mutual fund is (per Wiki): "A mutual fund is a professionally-managed firm of collective investments that pools money from many investors and invests it in stocks, bonds, short-term money market instruments, and/or other securities."

Which means that, in simple English now, in most cases a mutual fund is a group of many, from 10 to 500 or more, stocks. The number of stocks and which stocks are bought and which are sold is up to the fund's manager, who is a professional.

So, reading this, if you think about it logically, you notice two things:
1) You have no control over how your money is invested and
2) You are paying an "expert" to make decisions on what to do with your money for you (After all, no one works for free, do they? Well, perhaps some monumentally stupid college students in internships...).

Now, those two facts should set alarm bells ringing in your head. If you think that giving your hard earned money to a stranger and saying, in effect "Hey! Take this $10,000 and like, ummmm, turn it into like $15,000 for me in a few years OK?", then perhaps you should give ME your money. I know just what to do with it (NOW I do).

Second, if you have been reading my blog (you better!), you know my opinion on "experts" in this country. In short, if you see someone on TV, and he (or she) is introduced as an expert on the stock market, RUN. They are in effect saying "this is our TV station professional liar and cheat, who will now try to take your money from you."

The financial "expert" on TV will come on and with a serious face tell you which stocks are "hot", so "hot" that you need to buy them.

Now think. Why would this jackass come on TV and recommend stock to you, the viewer? So that YOU can make money - or so HE can make money?

Perhaps, just perhaps, he advised HIS existing clients to invest in so and so company, which he then goes on TV and promotes, saying it is "hot", effectively jacking up the price?


If you refuse to read my other article, you simply must see this article/video anyway. In it, Jim Cramer of CNBC, boasts of manipulating markets.

Basically, he calls all of us idiots - and he is right.
The article (unfortunately, the damning video was pulled) has Jim Cramer, the "expert" admitting and boasting that he himself manipulates markets with his TV show when he tells people what to buy - to make money off us, the suckers. (See mymoneyblog for details).

So, to sum up the "experts" on TV argument - if you pay attention to them and invest in stocks that they tell you to invest, you are an idiot.

So much for the "experts"...

Now, going back to mutual funds.
These funds are managed by financial "experts", who take your money from you and do various shenanigans with it. What should we measure the performance of a mutual fund by?


What is always shown on CNN, FOX, ABC and all the other news when they discuss the market? That's right - the S&P 500, the DOW or some other market index. Now, a market index is a sampling of many, many stocks that show how the market as a whole does right now (as in, "The index is 5 points down today, Bob!").

This measurement of the market is very easy to find out, and it has been measured forever.

Lets compare mutual funds to this market index, shall we?
*Here I am literally rubbing my hands in glee - money and fools who are easily cheated make me excited - I cannot help it, but to point and laugh*

Source: Image taken off

As you can see, compared to the market index, if you (idiot) choose to invest in a mutual fund, in a 5 year span you have 1/2 chance to outperform the market - make more money than the market index. In 10 years, 1 in 3. In 15, almost 2 in 10 to get rich. In 20 years, almost 1 in 10 to hit the goldmine.

Of course, if you are not special enough and you pick that mutual fund which does not outperform the market, you are losing money (Idiot).

Repeat after me (and

The average actively managed stock mutual fund returns approximately 2% less per year to its shareholders than the stock market returns in general.

Repeat it several times. Mull it over. Think about it. Go get some coffee.

Ready for more "good" news?

Now, this does not take into account any fees that the "expert" takes, as in the article it is clearly stated that "No sales charges, redemption charges, or advisor fees; taxes not considered".

*Loooooooooooong whistle here*

Think on that (or rather, let me explain this to you if you own a mutual fund and still don't gnash your teeth and get an attack of the Tourette Syndrome Coprolalia symptom).

Now, a mutual fund does not have much of a chance to outperform the market index, statistically speaking. The longer you have your money in a mutual fund, the less of a chance of outperforming the market is there, finishing with the 20 year 9 in 10 chance that you will LOSE money, or at least not make as much as if you invested in an index fund (Oh what's that you ask? Read on).

On top of that, there are fees.
After all, no one in America works for free, with the exception of some truly moronic college students (and volunteers who volunteer their time to help the less fortunate, but you catch my point). You, the client, PAY the "expert" to actively mismanage your money so that you can make less of a profit than the market index fund.

After all, all that "expertness" does not come cheap - the dude managing your money has years of school, a few nice papers saying nice things about him (certificates), and no hair (sorry for that digg - you know it's true!). You must pay him so he works hard and diligently every day, sweating, adding, calculating so that you (the idiot) make LESS money than an index fund member (Oh! Do tell about it already AG. Naw, not yet - mwhahahahaha! First you need to suffer some more).

The fees that you have to pay to the "expert" are joined by other expenses...

Every time the "expert" decides to sell or buy a stock, trying to beat the market, he must pay fees to do so (after all, when you buy or sell stock individually - you pay fees for that - same here, no difference). The more a mutual market is changed, the more stocks bought/sold, the more fees you, the investor (idiot) incur.

So, analysis time (Hooo boy!).
Mutual funds do not outperform markets in general, and the longer time you have your money in a mutual fund the more of a chance that your fund will perform below the market gains. But, and it is a BIG but, even if a mutual fund outperforms the market (its like winning a lottery - just doesn't happen... much), you the client have to pay the fees to the "expert" who is so good at losing you money and also, do not forget that you have to pay the fees for all the trading that the "expert" does to lose you that money.

So, even if your mutual fund outperforms the market, chances are the gains will be eaten up by the mutual fund fees.
*At this point I will do the happy dance and point at you, crying in the corner and thinking on all the money you have lost*
*Time for a happy dance*

Where was I?
*Oh yeah - hahahahaha*

There are other things to consider.
There is such a thing as a "load", beautifully explained by Loads section: "Mutual funds come in two broad categories. Those that have a sales charge and those that do not. Those that have a sales charge are called load funds and those that do not are called no-load funds. When a broker recommends a fund for one of her clients to buy, that fund will be in all probability a load fund, and the load, or sales charge, is pocketed by the broker and/or other middlemen as payment for the "service of helping you pick a good fund.""

Hopefully you were not stupid enough to invest in a "loaded" mutual fund? Right?

Especially since:
"(...)according to the latest survey by the mutual fund data analyzer Morningstar, even excluding the drag on returns if the load were included in the calculation, no-load funds actually have a superior record to load funds over the last 3-year and 5-year periods.

Let us repeat that. Funds that impose no cost to purchase have outperformed those that brokers pay themselves to find for their clients.

The simplest load to understand is the front-end load. Nothing too complicated about this one -- the day that you buy the mutual fund, you pay a sales fee, usually around 5%, and somewhere between 3% and 8.5%. Nothing confusing about this arrangement at all. You immediately lose a big chunk o' your money."

I have to say I admire how this financial industry is so good at parting people with their money.

One last thing to consider.
There are two things you can be sure of - death and...?
Taxes, of course.

When the "expert" manager of your mutual fund sells stock, you incur taxes on that sale - after all, you just made money - a profit. Be sure to report that on your tax form! (I love this site, and so should you by now): "This is not generally considered to be a problem by the mutual fund managers, who distribute these taxable gains to their shareholders and report their results for the year as if taxes did not exist."

You see, in the world of mutual funds advertising and financial reports, taxes do not exist. They are simply not important... right?

When do you pay taxes on mutual funds?
Lets ask the expert on CNN:
Basically, you can owe taxes on fund gains in three ways. The first is when you sell fund shares for more than you paid for them. The second is when the fund passes along to you interest or dividend payments it's received. The third is when the fund manager makes a profit by trading securities in the fund's portfolio and that profit is passed along to you in the form of short- or long-term capital gains distributions.

You have control over when you sell fund shares. But you don't control the interest and dividend payments or the capital gains distributions. The fund manager controls those.

Got it?

There are 3 ways when you have to pay taxes when you own a mutual fund, and only one of them YOU control.

Please don't read the rest of that article, as the expert turns into "expert" and says things like: "Ah, but there is an indirect way for you to gain some control over fund taxes. And that is by investing in tax-efficient funds. Basically, these are funds that minimize taxable distributions through any number of means.", which is bullshit.

Summing up
If you own mutual funds, you the client pay for:
1) the "expert" who actively manages your mutual fund stocks so you make less profit than the market index

2) the sales and buying of the stocks by the "expert", as he works very hard to lower your profits

3) the taxes on the sales of stock that the mutual fund manager does without any oversight or control by you (capital gains), the taxes when you sell the mutual fund, or any dividends by a stock in the fund.

Note that there are ways to invest in America that are tax free, which I did not get into in this article. Point 1 + point 2 is bad enough - taxes really are the icing on the shitcake here.

So what to do, chum?
Stop being an idiot. Do not invest in mutual funds, period.

An alternative to investing in the market is the index fund (Here it comes, finally, you say). What Is an Index Fund?
An index fund is passive management in action: it is a mutual fund that attempts to mimic the performance of a particular index. For instance, a fund that tracks the S&P 500 index would own the same stocks as those within the S&P 500. It's as simple as that! These funds believe that tracking the market's performance will produce a better result compared to the other funds.

Remember, when people talk of "the market" they are most often referring to either the Dow Jones Industrial Average or the S&P 500. There are, however, numerous other indexes that track the market such as the Nasdaq Composite, Wilshire Total Market Index, Russell 2000 and more.

In English, an index fund is a fund that tries to mimic the market. With today's technology, computer software and whatnot, it is doable and the corporations use better and better models to create index funds.

In my view, the broader the index, the better, the lower it is, the worse the fund is. Simply put (in my opinion), the more stocks you have in an index fund, the safer in the long term you are. S&P 500 index is good, but some market segments (like technology) can be (or rather - perhaps ARE) overrepresented in it, so if that market segment takes a hit (cough dot com bust cough) the index takes a hit.

That is why, while Standard and Poor's Index funds are very, very good (beat EVERY mutual fund), the Russell 2000 fund is better (simply because it has more stocks in it), and Wilshire 5000 is better still.

The advantages of investing in an index fund are:
1) You will not outperform the market, but will go with the flow of it, unlike the mutual funds, which 9 in 10 underperform the market index (before fees and taxes are even taken into account, which leads to point 2...)

2) You will pay minimal fees to the "expert", as there is not much the expert has to do here. He puts your money into the index fund and goes back to playing the Wii. No trades, no turnover, no taxes from sells of stocks.

3) You only pay taxes ONCE (typically): when you sell the index fund (for profit).

Again, to hammer it home,
"Expense ratios in the range for these funds is around 0.2-0.5%, which is much lower than the 1.3-2.5% often seen for actively managed funds. But the cost savings don't stop there. Index funds don't have the sales charges known as loads, which many mutual funds have."

Bonus Material: Even more fun and games that brokers play with their idiots, err clients - or - What questions should I ask my broker?

What's that you say? You are angry because even though you bought mutual funds, you are intelligent and savvy enough to at least not buy the "loaded" fund? And I am a "meanie"?

Because it is so obvious that the arrangement of giving 5% of your money away for nothing in return is such a lousy deal, mutual fund companies have begun to realize that people just won't fall for the front-load scheme forever. Something trickier is needed, and thus loads are now not always made explicit to the purchaser. Aside from the front-end load is the ominous sounding contingent deferred sales load (CDSL) or back-end load. This is a real masterpiece of the mutual fund industry. State-of-the-art deception (though we certainly expect to see something else come along at some point). The only purpose of a back-end load appears to be to confuse shareholders and make them think they are buying a no-load fund when they are not. A CDSL is simply a full load in disguise

Usually, funds that charge CDSLs are called "class B" shares, and often after the end of five years will convert into class A shares. A CDSL is a full sales load that is charged over time. Instead of imposing a 5% sales fee up front, a fund will eliminate the front-end load entirely but impose an exit fee of 5% if a shareholder leaves the fund in the first year. This exit fee will decrease each year by 1%; however, at the same time the fund is charging a yearly 12b-1 marketing fee of 1% each year.

Now call your broker. Ask him if you were stupid enough to buy the CDSL type mutual fund.

But before you do, ask him also if you have a "level" load.

One final load you should be aware of is the level load. This type of load, often designated as "class C" shares, usually charges a straight 1% in 12b-1 fees each and every year you own the shares. Though there is either no up-front load or a very small one (around 1%), because 1% is taken away in fees each and every year, the level load ends up being the most expensive type of load of all for a long-term shareholder. It's the load that keeps on keeping on -- siphoning away your money year after year after year after year after...

Well you are right on one thing - I am a "meanie".

You 100% sure you have a no load fund again?

*The goy does the happy dance yet again and points at you, while laughing*

To make it easier on your poor broker, ask him if he recommended you either a class 'B' share or a class 'C' share. I beseech you, do not threaten bodily harm on your broker when you hear the answers to your questions...

Next thing you need to ask your broker is what is the expense ratio of the fund. Per "The nifty thing about the expense ratio is that it wraps all these various costs and expenses into one number so that you don't have to do a lot of math."

So the lower the % number of the expense ratio, the less fees you are paying for the pleasure of holding that mutual fund. Obviously, you want it as close to 0% as you can...

Next, ask them about the turnover rate. This is "the percentage of a fund's holdings that change every year. "Turnover" is the gross proceeds from all sales divided by the total assets in the mutual fund. In plainer English, turnover represents how much of a mutual fund's holdings are changed over the course of a year through buying and selling."

Remember, you pay for each sale of buying of a stock. So the more turnover there is, the more you pay in fees to trade the stock. Sit down as possibly you will be quoted a figure of OVER 100% turnover (that you pay for).

*AmericanGoy finishes. He is tired from doing the happy dance, stopping, pointing at you, laughing and doing the happy dance yet again*

AmericanGoy's Final thoughts
I too traded actively in stocks, for years, without admitting to myself that if the "experts" who run mutual funds for a living cannot do it well, that chances are that I (and yes, YOU too), doing it part time, have limited chances also to beat the market and make a profit after fees and taxes. After all, I *am* so much smarter than everybody else right (And yes, you think the same thing - admit it. You'll show everybody how to beat the market, where countless PhD's have failed, you will achieve!).

Now, if after reading this, you, the reader will start to have a healthy cynicism to every "expert" shown on TV (and not just the financial/market "experts") pushing his own or his organization's agenda (after all, somebody pays him to say the shit he says on TV; nobody works for free right?), then this blog has achieved its purpose.

I am just like you. Just another idiot. My only weapon in this life is my very limited intellect and my google, and my life experiences. I too was an idiot and invested in a mutual fund. I too believed the experts on TV, on radio, in the newspapers, in the church.

Then I stopped - and started to think for myself.

I bid you all good day.

Edit: Again, the DIGGs do not show up on the main blog page but only if you click on the story itself.

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Anonymous said...

Anonymous said...

went to that site and clicked a story lol

I told you before the VASCO (Nasdaq: VDSI) earnings report that the stock was undervalued and belonged in your portfolio. With the results in hand, and the subsequent 34% share price crash, I'm hoping that you subscribe to the "buying in thirds" philosophy, so you can take advantage of an even better value proposition.

Here's what happened, and why I still believe in the data security specialist.

LOL "expert"

Anonymous said...

Yeah, you're of course right that *on average* mutual funds do not do that much better than the market for all of the reasons above.

Does that mean that all investing in mutual funds is a bad idea? No. You don't invest in the average of all mutual funds pooled; you invest in individual funds. Some are good and some are bad, and they average out to the center or below. If you're in a good fund, you can beat the hell out of the market.

That said, indexes are great, cheap and safe alternatives to mutual funds for those worried about the costs associated with mutual fund investments.

AmericanGoy said...

"Some are good and some are bad, and they average out to the center or below."

That's precisely what the article DOES NOT say.

Simplest thing to do - look at the picture posted with performances of mutual funds vs the market.

5 years - roughly 50-50 chance to beat the market.

But in 10 years, you have 1/4 chance to beat the market and 3/4 to underperform.

15 to 20 years investment in a mutual fund is guaranteed to lose you money.

That is because to stay even with the market, the mutual fund manager must BEAT the market, to cover trading costs, his fees, the fees of administration etc etc.

So to beat the market, a mutual fund must REALLY beat the market by a big margin, to cover all the fees.

That is what my article is saying.