ebook essays pieces of the puzzle
Wednesday, December 28th, 2011
quite a load

A recent posting on The Investment Fiduciary by Michael Zhuang highlights the one-two punch that some investment advisors land on unsuspecting clients.  It also points to the structural problems that many mutual fund companies face as the world changes.

In the example provided by Zhuang, an advisor talked a client into buying mutual funds with hefty front-end loads (the industry term for the sales charge that’s taken off the top of an initial investment).  Furthermore, those active funds have high ongoing management fees versus passive funds — and to add insult to injury, the advisor was charging a fat fee on assets under management.

The chart above pictures the effects of the burdensome fees.  The green line in each of the two panels depicts the stated return of an actively-managed fund in which the client invested.  A Vanguard alternative for each is in gold.

The red line in each panel is the performance of the active fund as adjusted for the front-end load that was charged and for the ongoing management fee paid to the advisor (once a quarter, in advance).  A management fee is not assigned to the Vanguard funds.  As a result, what you get by comparing the gold line to the red line is a contrast between the returns available to a self-directed investor in the passive Vanguard funds and the person that is feathering the nest of their “advisor” via the high-fee, actively managed funds.

In the top example, the passive fund beats the Invesco Van Kampen American Franchise Fund (VAFAX) handily, even before fees.  Adjusted for them, the gap is enormous.

In the bottom panel is Oppenheimer Developing Markets (ODMAX), a five-star fund (looking backward; Morningstar has not yet rated it on its new system).  It has had very good returns, but over this period it also trails a passive approach after all the fees are figured in.

In a world of freely available information, this is untenable.  It’s a breach of any reasonable standard of care for the advisor to feed at the trough like this — and the high fees and subpar performance of most mutual funds make their business models unsuited for today’s world.  It’s no wonder that the ETF juggernaut is winning the battle against them, although the real bloodbath is yet to come.  (Chart:  Bloomberg terminal.  Returns through 12/23.)

seeing the trades

The series on investment states and styles concludes with a reminder:  Transparency has great value.  That may seem obvious, but there’s nothing quite like seeing the trades to understand what is going on, yet even those that have the luxury often don’t take full advantage.