Arnold Kling  

Financial Crime

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Michael Lewis writes,


The millions of dollars that mutual funds have, in effect, stolen from their small customers are dwarfed by the billions they have wasted for them.

In his just-published book, ``A Random Walk Guide to Investing,'' Burton Malkiel shows that over the past two decades index funds have outperformed 88 percent of managed funds. That is, investors paid the vast majority of mutual-fund managers to grow their capital more slowly than if they had simply invested it in market indexes.


Lewis argues that the current mutual fund scandal is a distraction, and that new scrutiny and regulations will not benefit investors.

Just the reverse: Larded with even more regulation, more legal costs, more cover-your-butt provisions, mutual funds will see their costs rise. The added costs will be passed along to investors. Mutual-fund returns will be even less likely to justify fees.

A second, equally perverse, effect of this scandal will be to drive what talent there is in the mutual-fund industry out. In the wake of the scandal, the mutual-fund industry will become an even deeper drainage ditch for financial mediocrity than it already is.


Read the whole piece. Thanks to Zimran Ahmed for the pointer.

One of the magazines that rose and fell during the dotcom boom was called Upside. I remember that they had a cover story called "The Great IPO scam." It turned out to be about the fact that because stock prices for initial public offerings often went up by 100 percent or more on the first day, that this meant that investment bankers had underpaid venture capitalists and entrepreneurs for the initial stock.

I wrote a letter to the editor, which they published, in which I said that this was a minor story. In the grand scheme of things the real IPO scam was that companies with no earnings were being taken public at all. I argued that in the long run, the venture capitalists and entrepreneurs would turn out to be the scammers, not the scammees. History proved that to be the case.

The point of all this is that many journalists and lawyers seem to get the story wrong when they look at financial shenanigans. They see trees of misbehavior, but they miss the forest of what really lowers the return to the average investor.

For Discussion. Many economists would agree with Lewis that people over-invest in managed mutual funds and under-invest in index funds. Does this raise a public policy concern?


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COMMENTS (25 to date)
Boonton writes:

"For Discussion. Many economists would agree with Lewis that people over-invest in managed mutual funds and under-invest in index funds. Does this raise a public policy concern?"

Here's one, with the move to push 401K's and to push SSI into more of a 401K style model the mutual fund machine will become more of a creature that lives by gov't subsidy (like the agribusinesses that live off of subsidies for 'family farmers').

Last I heard the Bush administration was moving to make it easier for employers to hire consultants to give employees 'advice' on their 401K's. It's unlikely, IMO, that this advice will be avoid any fund with an expense ratio over 0.60%....avoid anything that isn't an index fund. More likely the efforts will be directed towards all types of expensive speciality funds & just as the agriculture business defends gov't subsidies in the name of the public good so will these funds.

Steve writes:

As more and more people invest into the index funds, they will become overvalued and managed funds will be able to outperform the indexes consistantly. It's only a matter of time.

Although, their services might still cost too much.

Lawrance George Lux writes:

Hedge Funds are as vunerable as Mutual Funds to Profits-taking by managers. No Funds have sure protection for the Investors. Boonton suggests there is an attempt to push Investors into Hedge Funds, which I doubt. I believe, though, there is an extreme attempt to push Investors into Treasuries; what with the huge increase of Government deficit spending. You scare Investors enough, they will start buying Bills and Notes, that are under-valued in Interest return. lgl

Boonton writes:

Actually as a group managed funds will never be able to out-perform index funds over any signficant period of time. James Boogle, for one, demonstrated this very simple proof in his book on mutual funds.

Index funds represent nothing more than the average of the market. As a group, managed funds can't beat their own average. You may have an individual manager here or there who has 'the gift' but that doesn't alter the fact that managed funds will always be losers...just like lottery players.

BTW, mutual fund manager is CBS Marketwatch's most overpaid profession: http://cbs.marketwatch.com/news/story.asp?guid=%7B954AA053-F953-43F3-BBC8-63D351A3BF2A%7D&siteid=google&dist=google

Steve writes:

Peter Lynch did it for 20 years, there will be others...

I agree that in theory that at most 50% can outperform while the other 50% underperform. However, if they can do better buying outside the S&P (like buying a mix of small/large companies), they why couldn't they beat the overpriced indexes?!?!

Mcwop writes:

Boonton writes: “Last I heard the Bush administration was moving to make it easier for employers to hire consultants to give employees 'advice' on their 401K's. It's unlikely, IMO, that this advice will be avoid any fund with an expense ratio over 0.60%....avoid anything that isn't an index fund. More likely the efforts will be directed towards all types of expensive speciality funds & just as the agriculture business defends gov't subsidies in the name of the public good so will these funds.”

This legislation was actually introduced by Boehner, and supported by Bush. Employers can already hire a consultant to provide advice for their employees. What cannot happen is that the advice provider cannot provide advice (or be the creator of the methodology) and manage the investment options. So mutual fund company X cannot serve as an adviser in addition to managing the funds. They would have to go to advisor company Z. The Boehner legislation would provide an ERISA exemption that allows the manager of the assets to also provide advice subject to certain rules.

This revolves around the ERISA prohibited transaction rule, where for example the manager of the assets (e.g. fund company) tells a thirty year old to move their retirement assets from a money market to a stock fund because it is more prudent for retirement savings – this is a prohibited transaction if the stock fund earns more in management fees than the money market (which is usually be the case.

Next point is the most major advice providers in the 401k industry (e.g, Morningstar, Financial Engines, GuidedChoice, AYCO), all give preference to funds with lower fees because that is the best determinant of performance. The results from the advice almost never include specialty funds (if a real estate fund is available it might get a small allocation because of low correlation with other markets), so long as there are other diversified options available.

Onto the discussion point many people do over-invest in managed funds, but index funds are not the be-all-end-all either. This depends on specific investor needs.

Example: investor has $10,000 to invest in stocks for higher return potential, but does not want too much risk. Do you automatically put this person in an S&P 500 fund? I would say no. You might recommend an equity income fund (focuses on dividends). This might not beat the S&P 500, but if it tracks it closely with less risk and volatility the investor might find it more attractive.

Unless public policy can account for varied investor needs then it is better not to get involved with regulations forcing people into say indexed funds. The rules for prudent investment behavior already exist, but it is the enforcement that is lacking.

Boonton writes:

"Peter Lynch did it for 20 years, there will be others..."

There will also be some people who will win the lottery two or more times. That doesn't necessarily represent skill anymore than what you would expect in a random world with a lot of coin flips, so to speak. A few managed funds will consistently beat the market.

Suppose you have an office building full of monkeys who 'manage' funds by throwing darts at the stock pages. You will have a few monkeys who will seem to beat the market for long periods of time.

"put this person in an S&P 500 fund? I would say no. You might recommend an equity income fund (focuses on dividends). This might not beat the S&P 500, but if it tracks it closely with less risk and volatility the investor might find it more attractive. "

Point taken, however your example is somewhat bounded by an investor who is 'doing it his way' by demanding to invest in stocks but wants low risk. Taken to an extreme, if you had a client who tells you "I want the smallest risk possible, but I want to invest in only Enron stock" then you have a rather limited range of things you can do.

Even in this case, though, a low cost index fund of the type of stock desired (dividend paying, tech, etc.) would be a better option than a higher cost fund managed by a manager who supposedly has the talent to find better equity stocks than the market average of all equity stocks.

Bob Dobalina writes:

"However, if they can do better buying outside the S&P (like buying a mix of small/large companies), they why couldn't they beat the overpriced indexes?!?!"

Right-o, Steve. Last I picked up Barron's, large companies are trading at a 30% premium to small companies (in trailing p/e). Further, some funds with more liberal prospectuses may be likely to make commodity, real estate, or international plays, all of which the S&P manager cannot do.

"Actually as a group managed funds will never be able to out-perform index funds over any signficant period of time. James Boogle, for one, demonstrated this very simple proof in his book on mutual funds."

Not quite correct. In the universe of all stockholders, mutual funds probably account for 20-30% of the ownership of domestic companies. Aside from this, you have foundations, endowments, insurance companies, defined benefit plans, individual investors, foreign governments, hedge funds, etc. It's quite concievable that mutual funds could outperform these other investors for a substantial period of time.

Bob Dobalina writes:

Furthermore, do you expect that the small firm effect and the low p/e effect will finally lose their status as "anomalies", or do you think managers that stick to this discipline will continue to be rewarded?

The EMH doesn't explain everything, Bogle.

Steve writes:

I don't think that this is an anomoly at all. I think there is a liquidity premium in small stocks that you are getting compensated for.

S&P index funds do not get that premium, and cannot get it since by S&P 500 stocks are the most liquid available.

If you invest for the long term, the liquidity premium is like a free lunch.

The longer people continue to pour cash into S&P funds, the more overvalued the underlying assets will get, and the more likely it is that an active manager will outperform these index funds because he has the ability to go after undervalued stocks that have huge potential. I'm not saying that the 500 is overpriced right now, but when everyone says the same thing ("BUY THE SPIDERS AND DIAMONDS!!") everyone is usually wrong!

gerald garvey writes:

Hope you all have gotten Boonton's point that the average active fund can't overperform, and that even in a world where no managers are aby good you will still see some "stars" just by chance.

One thing we have forgotten about in the public policy debate. Those stupid active funds provide liquidity and a potential reward for taking the time to do decent equity research. Otherwise we would have the Grossman-Stiglitz paradox where no one bothers to gather information.

Mcwop writes:

Note that even Mr. Bogle owns actively managed funds:

http://www.businessweek.com/bwdaily/dnflash/may1998/nf80529d.htm

The point he would make is that many actively managed funds can be run more cheaply. I would agree.

Jim Glass writes:

"I agree that in theory that at most 50% can outperform while the other 50% underperform."

No, managed funds also have fees and expenses that "the market" doesn't incur. So they must of necessity produce below-market returns (market minus expenses) on average. Which they do.

Ironically it's the fees that people pay for expert advice to beat the market that assure on average they will trail it.

"However, if they can do better buying outside the S&P (like buying a mix of small/large companies), they why couldn't they beat the overpriced indexes?!?!"

Once one gets outside the S&P 500 market caps are too small for those firms to have a serious effect on a big funds' returns.

But the real "market" -- the financial market -- includes much more than just the stock market. And 80% of the variation on the return on a truly diversified portfolio results from the *category* of investments one chooses (such as stocks, bonds, etc.) rather than one's particular investments within a category (e.g. picking individual stocks within the stock market is a mug's game, certainly for amateurs, even for many professionals as the managed funds show).

The best strategy over time for someone who has an open-ended investment horizon is to usually be mostly invested in stocks (because they produce the highest return on average) in a well-diversified low-cost manner (such as through an index fund) but to shift weight into other categories of investments when fundamentals between categories get knocked significantly out of line (by politics, unexpected events, whatever). Which happense infrequently (so this is not "trading" between markets) but not rarely.

The obvious recent example was when stocks were extraordinarily high and real interest rates were also high because the economys was hot, so bonds were low. If you thought that stocks were unsustainably high then you knew that their pending likley big fall would cause rates to fall and bonds to rise. And if stocks didn't fall you'd still get a nice return on interest from bonds. So while stocks were risky-high bonds were low-risk with an upside. That says, move into high-quality bonds (as Warren Buffett did).

The different categories of investments provide many more alternatives than just getting out of the S&P 500. Investing among them also lets one be a "fundamental" investor who keeps costs down without playing the mug's game of trying be beat a market from the inside (by picking this particular stock or bond or fund over that one). And diversification is *good*.

"Beating the stock market" is a rather myopic objective if it means losing only 30% while the market is losing 50%, when you could be making money in something else.

Jim Glass writes:

"I don't think that this is an anomoly at all. I think there is a liquidity premium in small stocks that you are getting compensated for."

Or to put it another way, an illiquidity volatility risk.

Also remember the higher return to small company stocks is not an every year thing -- it comes and goes for years at a time. You could invest for years and not get a bit of it. You have to invest for a long stretch *and* be well diversified across small stocks to expect to benefit from it. Investing in a small biased sample of small stocks won't do it. That's just gambling.

Bob Dobalina writes:

"And 80% of the variation on the return on a truly diversified portfolio results from the *category* of investments one chooses (such as stocks, bonds, etc.) rather than one's particular investments within a category."

Jim, I think you are referring to the Brinson study, and you ought not to pass this on as fact when it is widely misunderstood, and not widely agreed upon.

http://www.ivtb.nl/artikelen/DoesAssetAllocationPolicyExplain.pdf
http://www.fpanet.org/journal/articles/1997_Issues/jfp0297-art4.cfm

I'm not sure this invalidates your earlier points, but I couldn't let it go...

Bob Dobalina writes:

"Once one gets outside the S&P 500 market caps are too small for those firms to have a serious effect on a big funds' returns."

This is also misleading--

Large mutual funds can indeed play the small-cap game, but individual security selection becomes unimportant. To for an institutional-size manager to create alpha in small caps, he's got to play the sector rotation game. See Tillinghast, Joel.

Monte writes:

Where fund managers engage in illegal activities or violate investment company policy, government oversight may be warranted. But why should investment strategy become a public policy concern? The market punishes poor performance adequately enough, IMO. If we rely on government to protect us from the downside of a risky investment, how can we expect the market to reward us for it?

Bernard Yomtov writes:

The proper role for government is in protecting against misrepresenation, broadly defined to mean the fund not doing what it says it's going to do, and requiring thorough and understandable disclosure.

I would like to see something on the annual report that says, very plainly, if you had invested $100 in this fund one year ago you would have earned, say, $10, of which $1.25 was spent on fees, $.75, on commissions, etc, leaving you with $108. I know there is already reproting of expense ratios and the like, but I think this kind of explanation would be more informative.

Bob Dobalina writes:

Apparently, Bernard, you haven't read many prospectuses and annual reports lately.

A hypothetical expense illustration similar to the one you ask for is in every Fidelity prospectus.

http://personal.fidelity.com/fidbin/getewdoc.cgi?fund=21&doc=frame

for example

Bob Dobalina writes:

That was a wee bit snarky, Bernard. I apologize. And in the example I cite, management fees and trading costs are not decoupled, as you ask for them to be.

I'm not too sure why it matters, but...

dsquared writes:

On the pure mathematical point, Bogle, Boonton et al are all wrong; there is no *necessary* reason why any particular percentage of managed funds have to underperform the index, unless there are no investors other than managed funds and index funds.

Steve's point is also potentially relevant; if we get into a situation where there is a predictable rise in stocks when they enter the index and a predictable fall in stocks when they leave the index, then it is entirely possible to construct a scenario under which all managed funds outperform the index (the idea would be that there would in this case be a class of stocks which systematically underperformed and which were only held by index funds)

David Lloyd-Jones writes:

There is a perfectly clear distinction between savage and civilized societies: the savage ones put a disproportionate amount of their economic throughput into looking after infants and the young.

Civilization is when all the mechanisms of the world are dedicated to chanelling pelf to the old.

Mats writes:

Index funds are probably great value for money. All investments can't go via index funds though. If so, no money would then go into the process of determining the companie's relative share of market cap.

Monte writes:

Jim,

“Ironically it's the fees that people pay for expert advice to beat the market that assure on average they will trail it.”

Managed funds do play a role, in spite of the fact they’re usually outperformed by the indexes. Many investors are willing to pay experts to provide services like portfolio diversification, minimizing tax liabilities, and identifying risk tolerance. Your comment assumes all investors are sophisticated enough to attend these matters on their own and seek only to maximize their returns by attempting to “beat the market.” Concepts like EMH, expected return, and arbitrage are foreign to the average investor, whose preference may be deferring to a professional. It’s simply part of the risk-return tradeoff.

Bernard Yomtov writes:

Bob,

No offense.

I have looked at a fair number of prospectuses (prospecti?) and know that they report expense ratios.

I suppose what I would like to see is an actual number that tells the investor how much he paid for the fund's services. It may seem like a meaningless distinction, but I think it would have an impact.

By the way, I think the reported expense ratio excludes commissions. I'd like to see these reported, as well, as an indicator of trading activity to go along with turnover.

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