A Stitch in Haste

I have taken Henry Blodget (the man responsible for a good chunk of the hysteria mentioned in this post) to task before regarding his excessive cynicism and denigration of Wall Street. Well, his latest Slate article, on active versus passive management of mutual funds, is no different. But for his bitterness toward the industry from which he got himself banned, it would be a helpful guide for the lay investor:

Used properly, mutual funds are powerful tools. They allow investors with little money and time to pool resources and benefit from the same services, information, clout, expertise, and economies of scale as large institutions. They also provide immediate diversification, without the hassle and cost of acquiring and managing a portfolio of individual securities.

Alas, these benefits come at a price: First, mutual funds often aren’t used properly. Second, and more troublingly, the vast majority of funds get paid an aggregate of tens of billions of dollars a year for accomplishing nothing (or worse than nothing).

Exactly right. Most equity mutual fund managers simply do not “beat the market” for any extended period of time. Further, as a group they must fail to do so since, in the aggregate, they are “the market,” and the market cannot beat itself, especially net of brokerage commissions and other transaction costs.

Unfortunately, Blodget has to engage in yet another round of pouting and pooh-poohing:

According to study after study, the vast majority of fund managers can’t generate enough extra performance from active trading to offset the costs of their efforts (costs that include salaries, bonuses, and fund company profits). This problematic finding doesn’t stop fund companies from selling active-management prowess, of course — or from collecting huge active-management fees even when performance stinks. Your odds of picking a market-beating fund are somewhere between one in six and one in 30 (roulette-like); the fund industry’s chance of collecting big fees, meanwhile, is 100 percent.

If alternatives didn’t exist, active managers could just hide behind the rhetoric about offering small investors a simple way to pool resources and diversify, etc. Alas, alternatives do exist. Passive funds buy all the stocks that meet given criteria and leave stock-picking to folks who hope that they can defy the odds (and to their customers). Because passive management costs less than active management — fewer expensive MBAs, lower trading costs, lower research costs, lower taxes — passive funds generally do better than active funds: What they lose in performance (surprisingly little), they more than make up in costs.

Gee, Henry, tell us what you really think…

This is of course all true to an extent — but the order of magnitude is nowhere near as scandalous as Blodget would have you believe. It is definitely the case that management fees for actively-managed funds are usually higher than those for comparable passively-managed index funds. But the difference is rarely more than one percentage point (i.e., 1% of average net assets per year). And yes, that small fraction can have quite a noticeable impact on relative performance over time. Furthermore, management fees do generate “huge” fees for Wall Street — as it should be, since the total amount invested in mutual funds is itself “huge.”

But the true scandal over mutual fund costs has nothing to do with management fees — it has to do with commissions.

No primer here on front-end loads, back-end loads, share classes, 12-b1 fees, etc. If you need background, try here. The point is that index funds tend not only to have lower management fees, but they also tend to be no-load, which gives the investor a huge head start over the investor who pays a sales charge for an actively-managed fund. (Note: There are also countless no-load actively-managed funds. For such funds, what Blodget describes is 100% accurate — just not as substantial as when commissions are involved.)

Consider the analogy of bank accounts: different accounts at different banks may pay slightly different interest rates, but the real impact on your balance often comes from different fees: ATM fees, overdraft fees, bounced check fees, etc., that may dwarf a few basis points of interest rate spread.

For mutual funds, the commissions do not go to the portfolio manager, they go to the broker (of course, the two may work for the same firm, but that’s beside the point).

Blodget also conveniently omits the fact that those huge MBA salaries and bonuses are usually tied to the fund’s performance (i.e., better managers get more money) — unlike Blodget’s former profession (sell-side research analyst) where bonuses are tied to just about everything except stock-picking ability. Additionally, mutual fund companies are often known to waive management fees of poorly-performing funds in order to minimize redemptions. In such cases, Blodget’s whole thesis is nullified.

So why does Blodget pound his shoe about management fees but not commissions? Simple: He has no score to settle with brokers, but he has many to settle with the buy-side portfolio managers who were complicit in the stock research scandal that Blodget and his confreres brought upon the financial markets.

Don’t get me wrong — at the end of the day I agree with much of Blodget’s advice. Asset allocation (which he discusses elsewhere in his piece) is indeed the single most important (and often the least understood) aspect of personal investing. And yes, passively-managed index funds (if no-load) are almost always preferable to actively-managed counterparts.

It’s just unfortunate that Blodget lets his personal agenda cloud the message.

Related Post:
Taking Stock of Stock-Picking

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