Louis Lowenstein “The Investor’s Dilemma- How mutual funds are betraying your trust and what to do about it”
Lowenstein tables a shocking indictment of the U.S. mutual fund industry. He paints an industry which started out as a ‘trust’ where managers behaved as fiduciaries on behalf of customers who didn’t have the time, skill or patience to research and invest in individual stocks. It became an industry which has lost its way in transit.
He is particularly perturbed by the current state of affairs because of the rapid disappearance of defined benefit pension plans and the increased need of individuals to fend for themselves with their investments. U.S. social security replaces about 35% of the average employee earning about $50,000/year. To get to about a 75% of replacement of preretirement income, then with a 4% annual draw the individual would have to amass $500,000 of assets at retirement (and according to him less than 5% of Americans reach that level). This would require that individuals typically save about 15% of income per year over 30 years.
The indictment includes the following list of issues: -conflict of interest between fund sponsors/managers and investors -funds focused on asset gathering rather than performance -‘brokers’ (intermediaries), rather than the investors, became customers of the funds -fund managers invest in the fund management company, rather than the funds that they manage -opaque fees, expenses and costs (loads, 12b-1 fees, MERs, transaction costs, various fund classes, directed brokerage, soft-costs, revenue sharing) are all ultimately paid by the investor for the benefit lubricating fund sales/marketing channels in order to continue increasing the assets under management -even though in the fund business there are tremendous economies of scale, fees continues to increase with increasing asset base. -investors don’t get the benefit of reduced costs associated with size, in fact they end up paying for the marketing costs to attract additional assets, and the larger the funds the less likely that they’ll outperform; it’s a double-lose proposition for the investor, “inflated costs” and “obese inflexible funds” -fund management focus is on style consistency (i.e. to fit into one of Morningstar’s 9 style boxes) and relative performance to some (inappropriate) benchmark rather than absolute performance -fund companies often offering dozens of funds have effectively shifted selection responsibility to the investor; even worse, the investor has a better chance at picking good stocks to invest in, rather than good funds to invest in due to information opaqueness. -the problems are not just that the fees are a drag on performance, but they are affecting the investors’ ability to obtain objective advice -fund Board of Directors are “lapdogs” rather than watchdogs of the fund management company -high percent of the available total returns are going to managers, trading and administration
Early in the book, Lowenstein quotes Bob Goldfarb (manager of Sequoia) about his list of 10 funds which investors should consider (and presumably meet some, if not all of his selection criteria). These are: Clipper Fund, FPA Capital, First Eagle Global, Legg Mason Value, Longleaf Partners, Mutual Beacon, Oak Value, Oakmark Select, Source Capital and Tweedy Brown American Value. Unfortunately for Canadian investor, all but one of these is U.S. mutual funds, thus not available to us. However Source Capital (SOR) is a Closed-End Fund available on the U.S. exchanges.
Lowenstein’s “How to pick a mutual fund?” criteria include: -managers matter (even though fund companies try to focus you on the fund brand) -portfolio composed of a small number of stocks (30-40) -low turnover rate (<25%) -5 yr and 10 yr fund performance compared to the S&P500 (not Morningstar or Lipper benchmark which often are narrower and/or include impact of fees) -does manager “eat his own cooking” (i.e. is he significantly invested along with investors in his fund) -fund not too large (in fact often closed to new investors to prevent degraded performance) -managers are generalists looking for value everywhere -managers talk about searching for companies with good management and/or currently out of favor …and fees matter, but are less important than the above list!!!
Other points he makes are that for the truly long-term (buy-and-hold) investors, index funds work well assuming “rock-bottom” fees and costs and of course little or no capital gains (as turnover is minimal, typically 5%). He riles against advisors who continually churn investor’s money on the excuse of rebalancing or new trends thus generating costs, capital gains and taxes. Risk is should not be measured by volatility (market risk), but company’s business risk (market share, competitive threat, financial and management strength). Managers of selected funds invariably are value investors who invest according to Graham and Dodd’s “margin of safety” principle.
He finishes off his very interesting and revealing exposé with his selection of two funds: Fairholme and Wintergreen. The book is a very quick and rewarding read!!! Highly recommended!