The great mutual fund rip-off

Millions sink money into them, but do you really know what your fund manager is up to?

By Steve Bodow

Published June 13, 2000 7:00PM (EDT)

These should be jubilant times for mutual fund managers. With more than $7 trillion in their hands courtesy of 83 million Americans, you'd think they'd be tremendously popular -- the homecoming kings and queens of personal finance.

But the fund clique has encountered rebellion. The Securities and Exchange Commission has cracked down on mutual fund ads, already punishing such firms as Van Kampen and Dreyfus for enticing consumers with misleading come-ons. Actively managed funds, where high-salaried pros pick stocks, have consistently trailed auto-pilot index funds. And even industry guru John Bogle, the founder of the Vanguard Group and the father of low-cost investing, has publicly stated that most fund managers no longer serve clients like they should.

The primary reason for the industry's fall from favor: costs. They're too high and too confusing. Despite the economies of scale one would expect from managing ballooning assets, annual fund expenses have risen from 1.45 percent to 1.55 percent in the last decade, according to Morningstar. That may not sound like much, but left to compound for many years, fractions turn into big bucks. Worse, part of these costs go toward giving raises to fund runners, even if they don't deserve it.

Funds also are under fire for their less-than-friendly reputation among consumers. With arcane fees, tax complexities and reporting anomalies, funds virtually specialize in making comparison shoppers feel incompetent. And guess what? People hate to feel incompetent.

In 1999's bull market, mutual funds saw net contributions drop by 30 percent from the previous year. Many investors have realized that while individual stocks may carry greater short-term risks than mutual funds, they can assemble their own diversified stock portfolio at no greater risk. The host of e-brokerages and free portfolio-tracking Web sites, equipped with financial tools, has made it relatively easy and inexpensive for investors to serve as their own fund manager at a cost they can understand. Ten bucks a trade is 10 bucks a trade.

Compare this with mutual funds. A typical fund ad -- for example, the Strong Opportunity Fund -- touts itself in Money's July issue as having an average 10-year return of 18.68 percent. Not too bad. But the ad doesn't explain the fund's expenses. After spending 15 minutes searching Strong's Web site -- this on a fast connection -- I found a page that said the fund's expenses "are calculated on a rolling basis," hardly satisfying my curiosity. A little more digging turned up another page listing its annual expenses at 1.19 percent a year, or $119 for every $10,000 invested. It also disclosed that the fund charges no one-time sales fees, or "loads." (Many funds charge a load fee either up front, on the back end or both for the privilege of handing over your money.) The information may have been harder to find than a John Rocker fan in the South Bronx, but at least it was there.

But when it came to estimating how the fund would affect my taxes, I didn't have any luck. Again, I located data deep within the Web site. Last year, with the fund's shares trading mainly in the mid-$40s, short-term capital gains amounted to $2.06 per share, while long-term capital gains came out to $4.29. Had I owned shares, I would've paid the IRS just under $3 a share, regardless of whether I sold my portion or not. That unavoidable tax bill would have eaten a good portion of my profits.

If the fund industry had customers more in mind, it would find ways to clarify this muddy mess. But opacity works well for many managers. It camouflages the fact that so many get paid for investment "expertise," even though a mindless index fund that tracks the S&P 500 often outperforms them. (Over the past 15 years, the average actively managed large-cap fund had an annual after-tax return of 12.2 percent, compared with 16.7 percent for an S&P 500 index fund, according to the Wall Street Journal.)

In fairness, fund managers face an uphill battle trying to compete with the index model. Let's say our old grade-school chums, Goofus and Gallant, both have $10,000. Gallant puts his money in the Vanguard 500 Index fund, which by definition remains 100 percent invested in the S&P 500 Index, or all stocks.

Goofus, meanwhile, chooses a large-cap stock fund, whose well-educated chieftains do lots of research, schmooze with CFOs, attend conferences and so on. Because they're always looking for new opportunities, they usually have some assets in cash -- perhaps 3 to 5 percent. So the 10 grand Goofus put in his stock fund is really about $9,600 in stocks and $400 in cash. Now imagine that both Goofus and Gallant have a goal of turning their $10,000 into $11,000. The index will have to rise 10 percent, while Goofus' equity holdings will have to rise by about 14 percent or 40 percent more than the index fund just to match its results.

The average actively managed fund also flipped over 90 percent of its holdings last year, chalking up massive brokerage and capital-gains bills. With the numbers so stacked against them, why are there still thousands of fund managers trying to beat the more reliable index formula? Easy answer: because it's a great way to make a living. Despite their poor records, they continue to pull in new investors -- partly by obscuring their true costs and performance.

There is a straightforward step the industry could take. It could develop a standard way of showing returns after expenses, fees and taxes for average investors. (SEC officials have proposed something along these lines to loud industry objections.) Managers argue that customers fall into different tax brackets and remain invested for different lengths of time. All true enough. But instead of skirting the thorny issues of taxes and fees, fund managers should give us the real returns for say, a median-income investor -- married, two kids, $65,000. Trust us, we'll figure out for ourselves whether our taxes would be higher or lower.

More important, we'd have a much truer apples-to-apples way of comparing costs, a clearer idea of what's happening with our money and a greater sense of security -- which is what we were all after in the first place.

Steve Bodow

Steve Bodow is a writer in New York who has contributed to New York magazine, Wired and Feed.

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