Still unhappy with your stock-fund manager? You’re not alone. Bank of America Merrill Lynch’s quant strategists report this afternoon that only about 30% of large-cap active fund managers have beat the Russell 1000 index so far this year… It’s better than last year, when only one of five outperformed. (Barrons.com 07/12/12)

Should we be surprised by this?  Absolutely not.  Surprised is finding out what will be the next thing Pizza Hut stuffs in its crust, or witnessing the Cubs winning the World Series, or waking up past 8 am on a Saturday morning.  But surprised by the underperformance of actively managed mutual funds?  No way.  Sophisticated investors know that these performance figures are not anomalous.  It’s a statistical fact that over multiple year periods the vast majority of actively managed stock mutual funds will fail to beat the market (the percentage is as much as 80% won’t beat the market, but the percentages do vary slightly by study).  It’s also widely known by educated investors that the primary reason for this underperformance is high fees, as the average expense ratio for actively managed mutual funds falls in the 1.5% – 1.7% range (again, depending on the study). 

For decades now, actively managed stock mutual funds have been the favored investment vehicle for the retail investor—both those investors who self-direct their investments and those who use a broker.  An important reason for their popularity is due to the deep pockets of the mutual fund industry.  Yes, advertising can be a powerful medium especially when it masks the high fees and mediocre performance associated with these products.  An even greater contributor to mutual fund popularity is the fact that the brokerage & insurance industries are provided with financial incentives to push this product—which explains why the fees are so high in the first place.  You don’t even need Don Draper’s help when you have a hungry broker peddling an overpriced mutual fund for your investment portfolio.

But believe it or not, high fees and poor performance aren’t the main reasons to avoid actively managed stock mutual funds.   The main reason is because they are not transparent!   Sure, the funds do publish their top holdings once a quarter.  But this look is only a snapshot.  And the snapshot is usually grossly different than what goes on in the fund during the other 89 days in the quarter due to a dirty little practice called ‘window dressing’, whereby the fund’s portfolio is adjusted on the reporting day to either make it appear that the fund held winning stocks during the quarter or to make it appear that the fund is adhering to its mandate.  But a fund’s stated mandate, which is the market exposure that investors think they’re getting from the fund, oftentimes provides little resemblance to its ultimate invested exposure.  Think you’re getting a technology fund allocation with your investment?  Well, sorry, chances are almost 50% that you’ll be getting some other predominant exposure for your money like a bias to retailer or bank stocks.   With very little transparency, this could dangerously alter the risk characteristics of your portfolio in ways that you or your broker might not be comfortable with had you known.

I can provide a number of high profile examples where the lack of transparency within actively managed portfolios lead to complete financial disaster.  For brevity’s sake, let me leave those examples for another day and instead concentrate on a few benefits of mutual funds in general. 

The first is diversification.  With one investment, an investor gets instant access to tens or even hundreds of securities.  However, you can get the same type of diversification with a passively managed mutual fund (or ETF) which will provide a lower fee,  most likely better performance, and full transparency so that you—or your professional money manager—could better manage the risk of the portfolio. 

The second is that actively managed mutual funds actually make sense in the fixed income category.   A reason for this is that the fixed income index fund offerings are not nearly as robust as the stock index fund offerings.  Of greater importance, because credit is generally extended to the needy, a danger with fixed income index fund offerings is that your investment could possibly have a preponderance of entities that are desperate for funding, thereby increasing credit risk.   A good active fixed income manager— like DoubleLine or PIMCO—could help manage these issues.

The third is that there are a few stock mutual fund managers that go against the grain and can be considered worthy of investment.  At my firm we don’t invest in any.  But a case can be made to invest in a fund like Fairholme.  Bruce Berkowitz’s fund is unusual in that his positions are both concentrated and sticky, which makes for better transparency.  He also has an excellent track record.  There are a couple of other actively managed funds with excellent track records, but even less transparency.  If a money manager were to limit the investment to a small exposure within this type of opaque investment vehicle, it could be effectively managed with the risk management constraints.

In general, however, it boggles my mind that brokers can manage client money in actively managed stock mutual funds, with very little knowledge where the underlying investment exposures lie.

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