While reading the legendary investors’ letters to his Oaktree clients, we came across this hard-hitting analysis of the Mutual Fund Industry by Marks. Though written in 2003, we think that it still holds true today. Before you read further,we would like to put out a disclaimer first. We, at Zen Nivesh, are the biggest proponents of Mutual Funds for long-term wealth creation. The below commentary is the condensation of Howard Marks’ insights on the industry, which we believe are keeping in mind the investors’ interest. Hope you enjoy the read.
In his first memo of the year, Marks explores if the Mutual Fund industry is indeed insulated from the scams, scandals, and settlements, unlike the hedge funds, investment banks, brokerage firms, etc.
On September 3 2003, the Attorney General of New York State announced that Edward Stern of hedge fund Canary Capital Partners had paid $40 million to settle charges relating to improper dealings between Canary and several mutual funds. Canary had admitted to 'Mutual Fund Timing' and 'Late Trading'. These tactics take advantage of how the NAV of a fund is set post the market hours.
An academic study estimated that these tactics prevailing in the industry divert a sizeable amount from the funds' long-term investors but are not comparable to the total money invested in the mutual fund industry in relative terms. Based on the numbers cited in the study, for every $10,000 invested in the MF industry, $6 from the investors' profits is eaten away by the fund houses indulging in these practices. Moreover, according to Wall Street Journal, it could reduce investors' annual returns by 1-2%.
Though these tactics aren't widely in use now that the Canary case has come into the regulator's eyes, is the Mutual Fund Industry free from any shortcomings? Marks doesn't think so, and he gives the following reasons to back his claim:
1. Despite having a fiduciary duty towards their clients, the mutual fund companies' ultimate aim is to make more and more money - often at the expense of their clients. That is what a for-profit organization would do - unless it is the Vanguard Group. Clearly, the interests are not aligned in this industry.
2. People who are entrusted with keeping an eye on the functioning and conduct of a mutual fund - the Directors, cannot possibly monitor hundreds of funds and make informed decisions on the performance/conduct. Furthermore, most of the 'Independent' Directors of a fund are former employees. How likely is an independent director to remain a director after he votes to fire XYZ as the manager of the XYZ Fund? Why would a director rock the boat if he is paid millions in salary just not to look?
3. There's a lot of aggressive marketing and borderline mis-selling of the mutual funds. The commission structure at the mutual fund house or any Mutual Fund Distribution company goes against the clients' interests. Moreover, the propensity to sell whatever is 'hot' in the market is the primary reason for the average investors' underperformance. Plus, some of the fund houses are offering so many funds that it would be plausible to think that it is only to have something to show with more than 4-star ratings and mask the underperformance of their other funds.
4. It's rare for any actively managed fund to beat its market benchmark in the long run. Yet the size of the funds increases, and more shockingly, the expense ratio only goes up. It's probably the only industry where economies of scale don't apply. Even as the total assets of the top 25 equity funds increased 845 times over the last 51 years, the average expense ratio rose from .64% of assets to 1.50%, an increase of 134%. (Source: "The Mutual Fund Industry in 2003: Back to the Future," by John C. Bogle). One wonders how many of the "diligent, independent" directors resisted those increases.
So are Mutual Funds good?
For delivering retail participation and capital to the companies, they are invaluable. But by charging high fees and hyping hot investments, they are indulging in a great disservice to the average investors.
Are Mutual Funds a safe instrument for investing?
They're no safer than the markets they invest in or the boring passive funds. But cost aside, they're not much worse.
Are Mutual Funds scandal-ridden?
The Canary Capital incident ensured the dark arts of Mutual fund timing and 'Late Trading' didn't spread far, but the long-term structural issues discussed above are very troubling.
We strongly believe that only when the interests of the shareholders/investors take precedence the MF industry will emerge even stronger.