The Great Fund Failure

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Mutual funds were designed to let the small guy invest in the market cheaply and efficiently. The system doesn't work, though, when fund investors are too lazy to comparison shop for good values.

Frank Holmes is a conflicted man. He is the majority owner and chief executive of U.S. Global, a San Antonio, Tex. firm that offers mutual funds to the public. He also is a director of each nominally independent fund; that means he is supposed to act on investors' behalf and hold down the management fees that get paid to his own company.

His dozen funds have, as a group, put in a mediocre performance over the past five years while charging 2.5% in fees--nearly double the industry average, the Morningstar ratings service says. At the same time, U.S. Global runs in-house accounts for its own benefit. Who gets the best stock picks? Holmes insists there are "written procedures" to make sure fund investors get a fair shake. The procedures are not disclosed. You have to trust him.

For someone with $1.1 billion of the public's savings in his hands, Holmes is not too careful about who's on his payroll. One member of his professional staff was convicted of a double murder as a young man; when FORBES brought up this matter, Holmes professed to be unaware of it.

What Holmes is paying attention to is selling, and the rule in the money management business is to sell a fund when it's hot. U.S. Global's Eastern European Fund recently followed a dismal start in 2000 with two stellar years, garnering a four-star Morningstar rating and prompting Holmes to hit the road touting it. "Showing up in the rankings is the driver," he explains. "The press calls, people read the articles, and they open accounts."

In many ways U.S. Global is a microcosm of the fund business: shortsighted, poorly governed, weak on disclosure and riddled with conflicts of interest. This is an industry that pays lip service to helping investors achieve long-term goals while spending a bundle promoting the short-term payoff of hot-for-the-moment funds. It has tossed economies of scale out the window, charging more per dollar invested as fund assets have grown. Investors pay upwards of $100 billion in annual fund costs and fees. What do they get for this? Almost by mathematical necessity, they get, on average, mediocrity.

Vanguard's 500 Index fund--a passively managed fund that tracks the market--has returned 9.2% annually after taxes over the past ten years. The average actively managed equity fund, by contrast, has returned only 5.3% annually. That comparison, by the way, is too kind to the funds. This return is before subtracting sales commissions, and it counts in the fund average only the survivors. The stinkers tend to disappear. Just one of many examples: When UBS Global Strategy posted junky numbers after its 1999 launch, it disappeared into the dustbin of fund history. UBS folded it into a better-performing fund, Global Equity.

If fund customers aren't doing well, the vendors sure are. The average net profit margin at publicly held mutual fund firms was 18.8% last year, blowing away the 14.9% margin for the financial industry overall; the S&P 500's average was only 3%. This in a business that owes $2.1 trillion of its nearly $7 trillion in fund assets to a very easy sale--tax-deferred retirement plans.

The nation's 95 million investors in mutual funds are overwhelmed by the competing claims of 8,300 funds. They often are clueless about how to win at a fund game on which their financial futures depend: Despite clear evidence to the contrary, 84% believe higher fees buy better performance, according to an academic study last year. The Securities & Exchange Commission hasn't been much help. It could mandate disclosures that would cure this mass ignorance but is too timid to do so.

Economies of scale? This is a business made for them--but, outside of some genuinely cost-conscious purveyors like Vanguard and TIAA-CREF, the customers don't see the benefit. The business grew 71-fold (20-fold in real terms) in the two decades through 1999, yet costs as a percentage of assets somehow managed to go up 29%. The recent market doldrums have caused a slip in assets to $6.8 trillion, prompting the industry to plead poverty--and foist yet more fee hikes on investors. MFS Capital Opportunities lost 25% of investors' money in 2001 and another 30% in 2002. In April it raised fees $0.05 per $100 invested to offset the smaller base over which to spread expenses.

The industry often fails to grant the discounts that customers were promised. Nearly a third of fund investors eligible for quantity discounts on sales commissions haven't been receiving them, a study of 43 brokerages found. The average discount missed: $364. On another front, both the SEC and the National Association of Securities Dealers recently fined brokerages for loading investors into expensive share classes to maximize their own take.

Funds are sold, not bought. If they were bought by rational investors the low-cost, buy-and-hold index funds would have a much bigger share of the business. As it is, chasing after hot funds and short-term performance has yielded poor returns and big tax bills. Half a century ago funds held stocks for an average of five years; today the average holding period is 11 months. All told, for the average taxable investor, taxes, fund expenses and sales commissions eat up 3% of equity funds' assets each year, according to the Bogle Financial Center. That's almost half the long-run real return on stocks: Since 1926 stocks have returned 7% a year in capital gains and dividends, above and beyond inflation.

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