Don’t Throw out the Mutual Fund Market, Because of a Few Bad Apples

by | Dec 5, 2003

Previously, I dared to suggest that maybe the mutual-fund industry isn’t quite the “cesspool” that New York State Attorney General Eliot Spitzer says it is, and I criticized Spitzer and the Securities and Exchange Commission for panicking investors into dumping their fund shares. At the same time, I said that as long as everyone was […]

Previously, I dared to suggest that maybe the mutual-fund industry isn’t quite the “cesspool” that New York State Attorney General Eliot Spitzer says it is, and I criticized Spitzer and the Securities and Exchange Commission for panicking investors into dumping their fund shares. At the same time, I said that as long as everyone was rushing for the exits, there are some pretty good economic arguments why you should probably do it too.

Predictably, there were a couple of angry emails from readers who were shocked that I’d say anything that might be seen as sympathy for the mutual-fund devil. One reader wrote, “Don, you sound like an apologist for crooks.” Another called me an “anti-American crime monger.” Harrumph! That’s Mister anti-American crime monger to you!

Understandably, there were a number of emails from angry investors who will settle for nothing less than long jail sentences for the guilty fund company executives (since public hangings are probably out of the question). For some, it was simple moral outrage. One wrote, “The mutual-fund scandal strikes at the heart of fiduciary responsibility owed to mutual-fund investors.”

Some angry readers, though, didn’t seek vengeance. Another reader wrote, “If I cannot trust the managers of my mutual fund, I have no interest in giving them my money to manage. The only real way that I can punish such a company is to take my money out. That will speak much louder to them than any symbolic fines that the SEC might impose.”

For others, though, the outrage seemed less about the current scandals and more because they had lost money in their mutual funds since the market’s top in early 2000. Well, this may be a natural reaction, but it’s not a rational one. The sad fact is that almost every mutual fund, whether or not it was touched by the current scandals, has lost money in the bear market of the last three years. And there’s really no reason to believe that any of the improper actions at the focus of the scandals really had a substantial impact on performance.

Yet many investors are left with insult added to injury: holding fund shares at a deep loss, managed by companies embroiled in the scandal. Several wrote that they wanted to sell — both because of their outrage, and for the reasons I gave in a previous column — but they’re sticking around because they are still hoping to break even some day.

To these readers I’ll give a very basic and very important bit of investment wisdom, earned over 25 years of making every mistake in the book. Never — I repeat: never — hold a losing investment that your rational mind tells you to sell simply because your “pride” won’t let you book a loss. The fact is, you’ve got a loss whether you sell or not. So put your “pride” in your pocket, move on, and find a smarter home for your money.

One reader asked two interesting questions about the fines and reparations that will have to be paid. First, he asked, “Where does the fund get the money to pay the fine?” The answer is that it’s the fund manager, not the fund itself, that will have to pay the fine. Second, he asked, “Once the SEC receives the fines, does it give the money to the investors?” Sadly, no. But many of the fund companies that have settled with the SEC will be doing their best to estimate the losses to each individual investor, and make appropriate reparations.

With all the heavy fines paid and reputation damage sustained, several readers asked whether the most deeply scandal-plagued fund companies will even survive. The only honest answer is: Maybe not. The reason is simple business economics.

Mutual funds, like most businesses, benefit from economies of scale. When massive investor withdrawals shrink the size of a fund, its profitability for its manager implodes. And despite what Eliot Spitzer would like you to believe about the excessive fees charged by fund companies, the profit margins aren’t really all that great (especially after a bear market has already clawed the heart out of most companies’ assets under management). The fund companies experiencing the worst shrinkage will probably have to be merged into other larger companies. There are some fund companies today that are household names that won’t exist in two years. Mark my words.

Thankfully, there were many more emails from readers who — like me — were more angry at the regulators who have blown what is truly a fairly modest problem into an industry wide panic. One wrote, “The regulators’ actions amount to yelling ‘Fire!’ in a crowed theater because a small group was smoking in the balcony.” Another thought this whole affair is being driven by Eliot Spitzer’s ambitions to “make like a great crusader and then run for mayor of New York and be like Rudy Giuliani!”

One of my favorite observations comes from John Tamny of the Cato Institute, who sent me some thoughts about how the free market can deal with scandals like this all by itself, without any help from politicians or regulators. He makes the excellent point that “Impressive returns are what attract customers, and to the extent that mutual-fund companies allow excessive trading in their funds, it is their own returns that they’re imperiling.”

Something like that is already beginning to operate. Many readers told me that they’ve started bailing out of their poorly performing mutual funds — whether or not the performance is a consequence of the scandals — and moving instead into simple, low-cost index funds or ETFs.

Of course, I can’t think of any of this without remembering one of my own adventures in the mutual-fund business. Between 1999 and 2001, I ran a small fund company called MetaMarkets.com. We managed OpenFund, a mutual fund that showed its trades, positions and shareholder activity in real-time on the Internet. It was an experiment in total disclosure, undertaken during a great bull market when investors were so enthusiastic about stocks that such disclosure wasn’t even necessary — but it was fun.

Nowadays there’s not much fun in funds. And more disclosure is surely necessary. In fact, one of the fund companies implicated in the current scandals announced this week that it will be disclosing its portfolio holdings once a month (with a one-month lag), in order to restore confidence. It’s unfortunate that this should be the motivation, but more disclosure of this type is all to the good, for whatever reason.

This, and what were by and large very sensible and thoughtful letters from so many readers, give me confidence that the investing public is going to get through this crisis. When the dust clears, the fund industry will be a better place. And we’ll all be better investors.

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Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at www.poorandstupid.com. He is also a contributing writer to SmartMoney.com.

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