Originally published: July, 2004 (Phillips, Hager & North Investment Funds Quarterly Report)
Context of the article: In the spring of 2004, the Globe & Mail did a series of articles on the mutual fund industry. The tone was pretty damning. This article was my response.
It's been a couple of years since I wrote an article on this page titled In Defense of the Lowly Mutual Fund. That piece was written at the depths of the bear market and it addressed a number of hot points around mutual funds including negative returns, fees, tax efficiency and governance. Since we published that piece, investors have seen more bear market, followed by a much-welcomed recovery, and lots of dirt on mutual funds and mutual fund companies.
My impetus for revisiting the defense of mutual funds was the recent series of articles in the Globe & Mail called 'What they don't tell you about fixing your fund portfolio". The series hit the industry pretty hard by raising questions about fees, selling practices, advisor compensation and lack of controls on frequent trading.
I'd like to make four comments in response to all this scrutiny.
First off, I think the scrutiny is a good thing. In the short term, it may hurt the image of the mutual fund industry and impact fund sales, but pressure will bring positive change. As the Globe points out, there have been things going on in the industry that are not in the best interest of the individual investor. There have been questionable practices in lots of areas of the business: how funds are structured, the kind of funds offered, and how they are sold. In the corporate world, we have seen significant improvement in governance since it became a hot topic a few years ago. Perhaps intense scrutiny by the media, regulators and others will lead to improvements in our industry as well.
My second point is that the mutual fund industry's biggest issue and challenge is getting the customer to use the product correctly. The product may be flawed, as critics contend, but what has a far bigger impact on investor returns is improper usage of the product. Study after study shows that investor returns lag behind the returns of the funds they invest in. There are all kinds of reasons for this, but I think the fund industry is largely responsible. It preaches "advice, advice, advice", but its advertising and sales practices don't support that credo. All too often, we see fund companies touting their latest-and-greatest performance numbers. It seems that only the top-performing funds (based on past performance) get ink in the advertisements. Sales teams focus their efforts on what will sell, not what is good for the client. This approach makes advice-giving more difficult. It encourages performance-chasing and short-term investing, which in turn lead to inferior returns, smaller retirement nest eggs and lots of unhappy investors. In my view, the industry is far too focused on the returns of individual funds and is not paying enough attention to how the client's overall portfolio is doing.
With my next point, I risk sounding like a broken record, but what the heck. I really think the part of the investment industry that needs the most scrutiny is the less-regulated area of structured or alternative products. The world of investments "beyond the mutual fund" includes wrap accounts, funds-of-funds, index-linked notes, principal-protected notes and other variations. The abuses that the investing public suffers in this arena are more serious and harder to detect. The abuses come in the form of high, invisible fees; unattainable performance promises; and, all too often, a poor fit with the client's objectives. They are hard to detect because these products are more complex and transparency is very poor. In many cases, it takes a very sharp analyst to de-construct them and figure out how the product works and what it costs (we found that out ourselves, because we've done the analysis).
Finally, the defense part. The concept behind mutual funds is still sound. At its most basic, a fund is a vehicle that allows many people to pool their savings together and have the money professionally managed. It has some clear advantages over owning a portfolio of stocks directly. You receive professional investment management, which is necessary if you don't have the time, interest or expertise to do it yourself. You get a diversified portfolio, which is costly to do as a small equity or bond investor. And by getting together with other like-minded investors, you save on trading and other costs.
While the Globe & Mail series focused on the shortcomings of the industry, the eternal optimist in me detected an underlying theme that we strongly believe in at PH&N. If it's done right, with the best interests of the investor in mind, the concept of the mutual fund still makes sense.
At PH&N, we offer our clients two things: portfolio management and financial advice. We can deliver those services in any number of ways (believe me, we've researched them all), but we still think the good ol' mutual fund is the most effective vehicle out there.
Technorati tags: steadyhand