MUTUAL FUNDS: A LOOK AT WHAT IS SOLD VS WHAT YOU GET.
An Inside take on my former years in the financial advisory biz.
What Are Mutual Funds?
Most working Americans have mutual funds but don’t really understand how they work or what their true benefits are. If you look at your 401k most likely you will see obscure words such as “moderate allocation”, “Conservative US fixed Income” and the list goes on. Problem is that everyone asks “what do these actually invest in, and what am I being charged?”
Mutual funds are made out to be complicated because of lack of regulation, and obscurity on holdings within funds. This is the reason why most investors feel daunted to invest and rebalance them while in their working years.
Let’s look at the two fund types most investors invest in;
During the bull market craze in the 80’s-90’s hot shot managers such as Peter Lynch came to the scene with the Magellan fund. Investors wanted to not only participate in the stock market, they wanted to beat it. So many financial institutions came up with the notion of having ”in-house” mutual funds vs. sending that extra money off to a third party company. This they said would provide a one-stop solution to financial planning and collect additional fees for managing the assets of clients.
BlackRock Global Allocation Mutual Fund (allocation link)
Now looking at the link individuals know somewhat how this fund allocates capital but still doesn't know exactly what stocks or bonds it actually invest in, how does the manager determine when to get in and out of a stock, and if the manager can go short or not to benefit on market corrections. This is a major problem for several reasons in which I will lay out a few examples at the end of this essay.
The appeal to Active funds was that you could beat the stock markets without having to lift a finger. All you had to do was hand your money off to a hot shot money manager and he/she would find the opportunities in markets to get you better returns. It worked for many years until a combination of new products, bear cycles, and fee scrutiny came into the picture. I go over the main issues with mutual funds from a fee and conflict of interest standpoint in The True Cost of Mutual Funds Section.
PASSIVE FUNDS (INDEXING)
Pioneers such as John Bogle who founded Vanguard always believed that over time if one just follows the market through indexing they will do better than those who actively time the markets. Index funds are similar to active funds but they don’t employ a fund manager, they don’t have excessive marketing and payroll overhead, and lastly, their sole job is to just track whatever index the company sets out for it. Fees are usually 1/100th less than a standard active fund for the reasons stated above as well.
Here is a standard Index fund and its holdings:
Vanguard Total Stock Market Fund (allocation link)
Example: Someone who has $10,000 to invest but doesn’t want to perform extensive research performing the stock selection, they could just buy a fund that tracks the Dow 30 stocks. If the DOW is up 10% in a year, the index investor should be up close to that return (see: tracking error).
Index funds do well for the long-term investor who accepts they don’t want to outperform the markets, they just want to mimic them. This strategy can perform as long as investors perform periodic rebalancing (see: tactical rebalancing) and they do risk adjustments to more conservative allocation when they get older. This based on my experience is where investors falter with index funds which I speak about later in this essay.
THE TRUE COST OF MUTUAL FUNDS
Now that we have a better idea what mutual funds are, how they work, let’s look at why most investors (active funds) tend to give away significant returns in fees.
Recently there was an insightful documentary that frontline put out which they aptly titled “ The retirement gamble” which I included below. The point it was trying to drive home is how fees and wall street end up keeping most of your returns while you take all the risk with the portfolios they manage. Of course many didn’t watch this or it didn’t get a lot of press after coming out (maybe something to do with the financial lobby), but I wanted to expand on this documentary from the financial advisor's perspective/broker on how the main street continues to get the short end of the stick.
(watch it below)
The biggest MLM scheme in history
Now when we look at a standard 401k packet when employees start their new job, they usually see large investment firms and insurance company mutual funds. But how do they get placed in the plans over the countless other investments? and, what’s the relationship these companies have with the brokerage firm?
These investment and insurance companies employ thousands of salesman to go out and pitch financial advisors, brokerage houses, third party plan administrators, even small business owners to place employee assets with that fund. So without getting lost in the nuances of how these relationships work (over client’s interest) I will compare a mutual fund gathering assets to a standard MLM scheme which is below.
STANDARD MLM SCHEME:
The person at the top has a product or service which can be marketed by hiring two salesman who go out and bring in additional “reps”. The reps sign-up a certain amount of individuals in their “downline” and whatever those reps sell/bring in, their upline gets a piece. This continues multiples of times in the standard MLM program.
Second to the Top: Now that the mutual fund family is the go to fund for the big brokerage houses it’s up to the managers and decision makers of the firm to “motivate” their sales force (brokers) to push these funds at the expense of the clients goals. They know their metric is to at least have $100M transfer from the client’s money market funds or some other investments (that may be suitable), to this “better” or more “suitable” fund which the brokerage has a financial conflict with.
What incentive does this manager or decision maker have in making sure his/her salesforce of brokers meets this quota? Promotion maybe, or how about year end bonuses that wall street loves pumping out for just transferring cash from one side of the world to the other. And if they don’t meet this metric they usually are reassigned or resign to a lesser firm. But how do these managers motivate their salesforce (brokers) to push this exclusive fund family?
Third to The Top: We come to the face of the brokerage, the financial advisor. He/She is out for your best interest in making sure you meet your financial goals, plan for your retirement and all the other lovely adjectives in describing your financial freedom. Like everyone that works on wall street no one comes for the base salary, they come for the bonuses. The financial advisor knows that each year they need to bring in a certain amount of assets, they need to generate a certain amount of revenues quarterly through trading and mutual fund purchases, and they need to play nice with managers when it comes to promotion time.
They do this by placing one buy order for the mutual fund family which was pre-selected for the client before they even had a conversation regarding what their financial goals were.
At The Bottom: YOU! Now you have been asked a few questions regarding your risk tolerance, liquidity needs, and possibly what other assets you have to not over concentrate risk and poof! you’re now presented with a mutual fund out of thousands available to you that are strapped with appealing words such as diversification, long term track record, management stewardship and a host of other words that a consulting company tested and told the brokerage houses to say that would appeal to the mass affluent.
Now, you have a spanking new moderate allocation mutual fund which has an upfront sales charge of say 5.25%, and you have to wait several years in order to get your breakeven costs back. You’re left thinking your broker did all this research to screen various funds, performed due diligence on the management company, and aligned your goals with this fund. When all he/she did was read the morning memo on which fund will generate the most revenue to meet quarterly targets.
UNDERSTANDING A SHARES AND C SHARES
Now we come to the part where you pay your fees for the privilege of active management. There are two main ways to go to get your first 10k invested.
“A” Shares: This share type is suitable for the longer term investor. When I say long term I mean at least 10 years. The reason for this is when you put $10,000 into a fund right away a portion of that is paid out to the fund company as a “front load fee”. They will say this is better for you because over time it comes back to you, and, you pay less in fees longer term. This is all well and good but we are forgetting about the annual management fee which is usually 1% minimum. Now this fee represents the portfolio managers fee for rebalancing and actively managing your money. If they should happen to have a negative year in the stock market, they still get paid that fixed fee.
Usually investors will see that up front fee come back to their accounts after the 6th-7th year which you will see a comparison example below.
“C” Shares: This type of share class is suitable for shorter term investors who may need emergency liquidity in case they have a financial hardship. When you invest $10,000 all of that goes into the market vs. an A share which after the front end load fee is subtracted gets invested. Now instantly you may think why not just go into C shares if they don’t take a front end fee? Here is why there is no free lunch with C shares also.
You have to hold the C share mutual fund for at minimum 1 year or you pay a back end fee of usually 1%. Also, the annual management fee similar to the A shares is always going to be higher. Why? Simply because the fund family knows your money won’t be with them forever as a short term mutual fund holding, so they have to squeeze as much of their fees out of you before you decide to move to A shares or cash out.
Below I have included a link lining up the same mutual fund, time horizon, and rate of return and you will notice how A/C shares affects what you keep after 20 years of investing and fees. Be sure to scroll down to "over time" to see the disparity.
A COMPARISON OF TWO FUND SHAR CLASSES IN THE SAME FUND
Here are a few takeaways from this comparison:
- The cost for holding this mutual fund in A shares and C shares is the same usually in the 7th year.
- After the 7th year the C share will increasingly become more expensive to hold relative to the A share
- The A shares cost 5.25% up front which is $525 you’re down before your first full day in the markets. This obviously comes back to you but it takes a few years.
- This example assumes you will generate at least 10% every year. We all know this is not reality as 2000/2008 recently proved
- We’re not even considering the financial advisors 1% fee which he/she collected from you for just outsourcing your money to a third party manager over managing your assets themselves. What a sweet job they have!
What should you do now?
First understand that financial advisors under a brokerage firm or (wirehouse) by law just have to prove what they recommended was suitable for you. They DON’T by law have to align their interest with yours when it comes to investments. Only fee only RIA’s are held to higher standards and have to align their views with yours.
Ask more questions. People hate to interrupt financial advisors or financial ‘experts’ for the fear of looking stupid or ignorant on the subject. When it comes to your money be as much of a pest when you ask how does this product help me get to a certain point in my financial goals.
Learn to trade and invest for yourself. With technology such as mint.com, online planning platforms, and trading programs like ours, the standard way individuals get advice and invest are changing. This is no longer the 80’s where people at cocktail parties boast about how savvy their broker is, they now talk about how they made money themselves or found a more cost effective way to a financial goal.
Understand what you're investing in by asking questions. And if you really want to take control of our own destiny when it comes to investing, be sure to join us tonight at 7:30pm EST for our webinar on how to trade part time while maintaing your career.
REGISTRATION LINK: HOW I MADE 20K IN FEBRUARY TRADING PART-TIME WHILE MAINTAING MY CAREER.