Is This the Twilight Era for the Managed Mutual Fund?

Once a "safe bet," mutual funds are facing a rocky future as investment managers come under fire for such mismanagement as arbitrage trading. These alleged double dealings will end up costing investors a bundle in the long run. Are we witnessing mutual funds' swan song?
by James Heskett

Summing Up

What Will it Take to Save the Managed Mutual Fund?

In this month's column, I purposely took what I assumed was an extreme position in asking if this was the twilight era for the managed mutual fund. The responses the column generated from individual investors, heads of organizations representing groups of investors, and from those in the U.S. and other countries—if at all representative—provide what is for me a rather sobering assessment of the future of these funds.

At one end of the spectrum are the feelings largely of investors. As Chris Lee put it, "As a small individual investor, I feel powerless to control or even understand how my mutual funds operate." Anupam Bordia comments, "the mutual fund scandal will shift public trust towards index funds."

There is also a suggestion that the job of the money manager may change. Remarking, "we have probably seen the beginning of the decline of the actively managed mutual fund," Charles Broming expressed the hope that "money management will become another technical job and compensation will reflect its real added value."

Part of the problem may be the perception created in press coverage of mutual fund management misdeeds. And part may be in the general ignorance about how funds are managed and investors charged for the services. Whatever the cause, according to William Donoghue, "The financial McCarthyism of the press coverage of anyone who ... proactively manages money as a vile 'market timer' is a sad commentary on how inflexibly the mutual fund industry is viewed by academics, regulators and distributors."

Richard Eckel suggests that both perceptions and real problems will be addressed when, among other things, interests of managers and investors are aligned. As he says, "Linking management fees/rewards to fund performance would be very attractive to investors: Who can argue with shared ambition?"

The importance of these questions lies in the heavy reliance that so many people deep into saving for retirement will place on others to manage their savings, particularly in a future in which Social Security will account for a smaller share of retirement income. How can their options best be preserved? Is the managed mutual fund worth saving? If so, what needs to be done? And how fast must the industry move to correct investor perceptions that appear to have been formed over a number of years? Or is all of this just an overreaction to phenomena that will recede in perceived importance to investors and money managers alike as other concerns crowd them out in our collective consciousness? What do you think?

Original Article

Since their creation in the 1920s, mutual funds have progressively become the cornerstone of most individuals' investment portfolios, providing the diversity that is generally agreed to be an important element of any investment strategy. But in recent weeks, fund managers have increasingly come under fire, casting a shadow over the entire industry.

The alleged problems include managers of fund families who allocate investments among individual funds in which they may have a management or ownership stake. This allows some investors (particularly hedge funds) to trade in and out of funds quickly while prohibiting others from doing so, presumably in return for favors. Some favored international funds managers with investments spread across time zones who have a continuing stream of fresh investment information participate in after-hours "arbitrage" trading at prices set just once a day.

The net effect of much of this alleged activity is to tax long-term investors in order to reward short-term investors. In a two-year-old paper, "Who Cares About Shareholders? Arbitrage-Proofing Mutual Funds," Eric Zitzewitz, assistant professor of strategic management at the Stanford Graduate School of Business, estimates that the total cost to long-term mutual fund investors of just the latter of these practices is about $5 billion per year.

John Bogle, founder of the Vanguard family of mutual funds, suggests that mutual fund investment management is just as problematic as fund governance. Some time ago he concluded that mutual fund investment managers: (1) through their investment decisions destroy as much value for investors as they create—a view for which there is a great deal of evidence—and (2) through their behaviors destroy value for investors by running up high management fees, in part for their own enrichment. As one might imagine, he is not popular with many of his peers in the mutual fund industry. To combat these practices, he has been perhaps the strongest advocate for indexed (vs. managed) funds as well as management incentives for minimizing costs to investors.

At a recent discussion of Professor Zitzewitz's ideas, one academic in the audience commented, "Why is this such a moralistic issue? Maybe the time of the mutual fund has simply passed, and we should just use other instruments."

What is the answer to allegedly poor mutual fund governance practices? Can mutual fund directors, often responsible for dozens of funds in a fund family, be expected to exercise adequate oversight? Or must practices be corrected through added regulation? Or is the problem, as Bogle suggests, deeper than this, extending to actual fund investment management? If so, what could be done to align managers' interests with those of investors? Or is this really the beginning of the twilight era of the managed (vs. the computer-administered indexed) mutual fund business? If so, does it present an opportunity for mutual fund entrepreneurs to devise new vehicles for investors seeking diversification? What do you think?

    • Anonymous

    I've invested in Putnam, Templeton, and Fidelity, but found that all three were always very obscure about the fees they charged; and when I did figure out the fees, I thought they were pretty high given that I seldom bought or sold except to continuously reinvest dividends back in my holdings. The bulk of my pension funds were with TIAA/CREF. Its fees were much lower and it had a board of overseers who were professors with some knowledge about finance and investing as well as a stake in good performance in the TIAA holdings. My level of trust in the other mutual funds was very low, and I turned out to be right that they were not trustworthy. Business leaders and managers who can't recognize public and investor trust as a fundamental requirement of their business should be fired or barred for life.

    • Anonymous

    Management of a stock should be more about mid- and long-term ownership of a company than the inefficient, quick positioning of a day trader (institutional or otherwise) trying to beat out each news cycle. Traditional Wall Street votes its feelings about the management of a company with its feet—selling. Maybe a money manager can increase focus on improving management by voting their shareholders' rights. A new role for money managers, possibly with industry expertise, could appear; and they could earn their keep as fiduciaries by effecting changes from within a company. What type of returns will everyone see if everyone is in the index funds?

    • Ernest

    As soon as I can beat the market on my own, I'm out of mutual funds.

    • Anonymous

    I think the mutual fund program is still a good program for the guy who does not have time to do all of his research. Why should a few of the big apples spoil the bushel? My feeling is that in this day and age we have people in high positions who lack morals and make bad decisions.

    • David Ellison
    • Sydney, Australia

    Professor Heskett's is a very interesting and thoughtful comment on funds. The points raised have been turning over in my mind for some three years now, but I can see I will have to apply myself a little more conscientiously to the problem. The fees that the funds are taking out here in Australia for what is abysmal performance are a real cause for concern.

    Unfortunately, a federal government financial instrument for retired persons, an allocated pension, is almost forced on you by the tax laws. The impact of the last few years in financial markets, when allied with the tax laws, has destroyed the capital base of a good many retired Australians.

    It seems to me that either index funds or a self-managed share portfolio are the sensible approaches. Anyway, thanks to [this] thoughtful article, I will be giving the question a great deal more thought.

    • Chris Lee
    • VP, MLD Consulting

    As a small individual investor, I feel powerless to control or even understand how my mutual funds operate. I believe fund managers generally have others' interests, including their own, ahead of mine. Most importantly, I am skeptical of the ability of fund managers to consistently beat the market.

    • Charles Broming
    • President/CEO, Association of Angel Investor Clubs, LLC

    I believe that we have probably seen the beginning of the decline of the actively managed mutual fund. The record of such funds is poor. About 15 percent achieve or exceed the "placebo" rate of return over any long-term holding period.

    The number of fund users who will understand the basic inefficacies of this model will grow as their returns continue to be less than overall market returns. And the heroes and myths of this period (Warren Buffett, Peter Lynch, Ned Johnson Sr.) will be viewed, in retrospect, as "six sigma events" that merely reflect a rare combination of diligence and luck. Hopefully, money management will become another technical job and compensation will reflect its real added value.

    • Anupam Bordia
    • Pr. Engineer

    The mutual fund scandal will shift public trust towards index funds, which have been the direction lately.

    • Richard A. Eckel
    • President, Systems Synergy, Inc.

    Mutual funds are the only opportunity for small investors to do better than the market average without disproportionate expenditures and risk. That individual life earnings are at stake demands investment vehicles not run by a club of thieves. If individual funds are to survive their scandals, they must acknowledge culpability and refund customer losses out of their own profits. The attraction is that atonement and enhancement will add vigor to the return of small investors to the funds market, and capital to the market as a whole.

    The question you raise was never a one of investment acumen. In any market, certain strategies and sectors will be successful, and their complements equally unsuccessful. The market will square the success and failures of investment strategies as reflected by redemptions and deposits. Investors intrinsically understand the relationship and accept the risk (commitment) balanced against the possible rewards (opportunity).

    What is in jeopardy is the confidence of the investor, the little guy, in the investment instrument that he or she chooses. When presented with a set of rules for an instrument, the customer has every expectation that the rules will be respected and enforced equally. It becomes a moralistic issue when those in whom trust has been placed abrogate their duty in devotion to a higher self-interest.

    Application of technology to control order dating or calculate share prices dynamically would significantly reduce arbitrage but not the neglect of enforcement. Linking management fees/rewards to fund performance would be very attractive to investors: Who can argue with shared ambition? Fund administration will benefit from tightened enforcement and modifications to management incentives, but these will never be driven from within an industry that is profitable, even when its patrons are not.

    • William E. Donoghue
    • Chairman, W. E. Donoghue & Co., Inc.

    The mutual fund industry and its shareholders have been hurt more by the revelation of the impact of its unwillingness to innovate or be responsive to its shareholders' needs and its obsession with distribution at all costs than anything in the current scandal. The financial McCarthyism of the press coverage of anyone who trades mutual fund and proactively manages money as a vile "market timer" is a sad commentary on how inflexibly the mutual fund industry is viewed by academics, regulators and distributors.

    I share your concern about the future of the managed mutual fund industry because it directly effects the one single demographic concern that faces us all: "How will the baby boomers be able to afford to retire with dignity if mutual fund families continue to keep growth funds from growing, value funds from adding value, and mutual fund managers from managing efficiently?"

    Successful market timers simply use sector funds and ETFs to follow the trends of the market. My firm is such an example, as we have had three of our portfolios ranked #1 in their categories at Morningstar Principia Pro Separate Accounts in the past year, two for five-year performances. I mention this not to brag but to indicate that there are strategies beyond buy-and-hold and fund portfolios that do not benefit from investing in tight Morningstar style-boxes. In fact, Morningstar has only recently added a "bear" market category, showing how much pressure there has been to deny investor the information to succeed.

    Academics agree that the stale pricing that created the "market timing" advantage reported by the press is limited to a few international funds and has literally been stopped in its tracks by an over-vigilant press looking for easy answers.

    So why is Congress trying to impose redemption fees on domestic stock and bond funds and the SEC trying to force an inappropriate, draconian 4:00 PM cutoff time on mutual fund trades that will only hurt small investors with staler and staler values by forcing them to submit trades earlier in the day?

    Mutual funds are still the best vehicle for many investors' savings. However, the institutionalization of fund distribution methods and the politicization of fund selection by 401(k) and fund managers are getting in the way.

    • Rod Morley

    Mutual funds, at their origin, offered investors access to the world equity markets with ready-made diversification, neither of which were available to them in any other form.

    Since then the world markets have become more transparent and accessible through the Internet, while at the same time, as the mutual fund industry matured, two thirds of "active" mutual fund managers fail to beat a passive index, as management fees and portfolio turnover costs subtract value from the investor's account.

    As the majority of an investor's return is predetermined at the asset allocation level, an investor seeking equity exposure should get pure equity beta exposure at lower cost through owning stock index tracking shares rather than a mutual fund.

    Hedge funds are focused on exploiting market inefficiencies that should in time be arbitraged away. Whether certain forms of arbitrage are ethical or not is down to the personal tastes of the hedge fund manager; but when mutual funds collude in illegal forms of trading, they highlight how a few bad apples will try to find ways of extracting personal gains from an industry those time, they know, has passed.