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Steve's note: Today's essay is written by one of my favorite investment advisors in the world, Chris Mayer. For a unique twist on how to invest in mutual funds, read on.
Insider Reveals the Secret to Making a Fortune in Mutual Funds
By Chris Mayer, editor, Mayer's Special Situations
June 28, 2008
If you had to design a poor investor, you need look no further than the typical mutual fund.
The typical mutual fund turns over its entire portfolio at least once per year and owns 160 stocks. These two things often lead to mediocrity: too much trading and too many stocks. (Nowadays, investors even flip the funds. Forty years ago, the average holding period was 14 years. Now, people flip funds every few years.)
All that churning fattens the brokers of the funds. And the funds often have unseemly arrangements to direct commissions to brokers who help market the funds. Owning all those stocks also means the fund managers often know little about what they own.
No individual stock matters much, nor does any single issue make much of a difference, so why bother looking at any of them in detail? It is little wonder the typical mutual fund puts in such an indifferent result. But there is much more...
A new book by Louis Lowenstein (The Investor's Dilemma) really hammers these points home – along with some new ones. This book will make your blood boil. You shouldn't buy another mutual fund until you've given the ideas in this book some thought.
To begin, the individual investor is in quite a pickle. Lacking the necessary time, interest, or aptitude for investing in stocks, he or she often looks, naturally, to professionals. Usually, this means tucking some money into a mutual fund.
But where to begin? The number of mutual funds out there grows like kudzu. There were 300 in 1980. There are over 4,800 today. Fidelity alone has over 300 funds, in 24 different flavors. You've no doubt seen the absurd slicing and dicing of mutual funds – mid-cap growth, small-cap value, large-cap blend, etc., etc. These are pointless distinctions. An investor should go where the value is – no matter what it's called.
These mutual funds are huge forces in the market these days. They own one out of every four shares of stock out there. It was only 8% as recently as 1990.
The reason there are so many – and why they are so large – is because running money is extremely profitable. A lot of brainpower goes into figuring out how to get your money in a fund.
As becomes clear by reading Lowenstein's book, most fund companies have little interest in how well investors actually do in their funds. Instead, mutual fund companies are most interested in growing the amount of assets they manage. This is how they get paid.
Lowenstein runs through the example of T. Rowe Price, which is generally held as one of the better fund houses. T. Rowe earns a net profit of 28% after taxes. This is an enormous profit margin.
"It's difficult to think of many legal businesses with comparable returns," Lowenstein writes.
Now it becomes clear why Fidelity has over 300 funds. "Fidelity is a marketing construct," Lowenstein writes, "not something fashioned to enhance the welfare of investors." Lowenstein also points out that mutual fund groups spend more on marketing than they do running the funds.
So it's not hard to understand why the management companies make all the money. Instead of investing in T. Rowe funds, you'd have done better investing in T. Rowe itself.
Paul Samuelson, the famed economist, had a pithy quote on this: "There was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon: behind the bar and not in front of it."
This is something the insiders understand well. Lowenstein goes through many examples. Brian Rogers, chief investment officer of T. Rowe, is one. Rogers has only $1 million in T. Rowe's funds. By contrast, he has $65 million in the management company.
I have to agree with Rogers. Bought at the right price, money management companies are wonderful investments. They don't have to spend much money on equipment, and they have high profit margins... so they throw off lots of cash.
Take a look at the multiyear uptrends in T. Rowe (TROW), U.S. Global (GROW), Janus (JNS), and Cohen & Steers (CNS), and you'll see what I mean. Specialist money managers can also be great ways to invest in a broader theme, like commodities or real estate.
Don't get me wrong... there are some good mutual funds out there.
Lowenstein talks about some in his book, and I have a list in my book Invest Like a Dealmaker. But my point today is, you're usually better off investing in the mutual fund manager instead of the mutual fund itself.
Good investing,
Chris Mayer
Editor's note: Chris Mayer writes Mayer's Special Situations, a monthly advisory we consider required reading at DailyWealth. With Chris' research, you can always count on contrarian investment ideas you won't read about anywhere else.
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