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Searching For A Port In A Storm Of Bad Behavior

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August 20, 2009

Since I began complaining about manipulation of the stock markets back on December 18, I’ve been comforted by the fact that a number of bloggers have voiced similar concerns.  At such websites as Naked Capitalism, Zero Hedge, The Market Ticker and others too numerous to mention —  a common theme keeps popping up:  some portion of the extraordinary amounts of money disseminated by the Treasury and the Federal Reserve is obviously being used to manipulate the equities markets.  One paper, released by Precision Capital Management, analyzed the correlation between those days when the Federal Reserve bought back Treasury securities from investment banks and “tape painting” during the final minutes of those trading days on the stock markets.

Eliot “Socks” Spitzer recently wrote a piece for Slate, warning the “small investor” about a “rigged” system, as well as the additional hazards encountered due to routine breaches of the fiduciary duties owed by investment firms to their clients:

Recent rebounds notwithstanding, most people now are asking whether the system is fundamentally rigged.  It’s not just that they have an understandable aversion to losing their life savings when the market crashes; it’s that each of the scandals and crises has a common pattern:  The small investor was taken advantage of by the piranhas that hide in the rapidly moving currents. And underlying this pattern is a simple theme: conflicts of interest that violated the duty the market players had to their supposed clients.

The natural reaction of the retail investor to these hazards and scandals often involves seeking refuge in professionally-managed mutual funds.  Nevertheless, as Spitzer pointed out, the mutual fund alternative has dangers of its own:

Mutual funds charge exorbitant fees that investors have to absorb — fees that dramatically reduce any possibility of outperforming the market and that are set by captive boards of captive management companies, not one of which has been replaced for inadequate performance, violating their duty to guard the interests of the fund investors for whom they supposedly work.

Worse yet, is the fact that mutual funds are now increasing their fees and, in effect, punishing their customers for the poor performance of those funds during the past year.  Financial planner Allan Roth, had this to say at CBS MoneyWatch.com:

After one of the most awful years in the history of the mutual fund industry, when the average U.S. stock fund and international fund fell by 39 percent and 46 percent respectively, you might expect fund companies would give investors a break and lower their fees. But just the opposite is true.

An exclusive analysis for MoneyWatch.com by investment research firm Morningstar shows that over the past year, fund fees have risen in nearly every category.  For stock funds, the fees shot up by roughly 5 percent.

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Every penny you pay in fees, of course, lowers your return.  In fact, my research indicates that each additional 0.25 percent in annual fees pushes back your financial independence goal by a year.

What’s more, the only factor that is predictive of a fund’s relative performance against similar funds is fees.  A low-cost domestic stock fund is likely to outperform an equivalent high-cost fund, just as a low-cost bond fund is likely to outperform an equivalent high-cost fund.   . . .  As fund fees increase, performance decreases.  In fact, fees explained nearly 60 percent of the U.S. stock fund family performance ratings given by Morningstar.  Numerous studies done to predict mutual fund performance indicate that neither the Morningstar rating nor the track record of the fund manager were indicative of future performance.

Another questionable practice in the mutual fund industry — the hiring of “rookies” to manage the funds — was recently placed under the spotlight by Ken Kam for the MSN TopStocks blog:

In this market, it’s going to take skill to make back last year’s losses.  After a 40% loss, it takes a 67% gain just to get back to even. You would think that mutual funds would put their most experienced managers and analysts to work right now.  But according to Morningstar, the managers of 28 out of 48 unique healthcare funds, almost 60%, (see data) have less than five years with their fund.  I think you need to see at least a five-year track record before you can even begin to judge a manager’s worth.

I’m willing to pay for good management that will do something to protect me if the market crashes again.  But I want to see some evidence that I am getting a good manager before I trust them with my money.  I want to see at least a five-year track record.  If I paid for good management and I got a rookie manager with no track record instead, I would be more than a little upset.

Beyond that, John Authers of Morningstar recently wrote an article for the Financial Times, explaining that investors will obtain better results investing in a stock index fund, rather than an “actively managed” equity mutual fund, whether or not that manager is a rookie:

For decades, retail savers have invested in stocks via mutual funds that are actively managed to try to beat an index.  The funds hold about 100 stocks, and can raise or lower their cash holdings, but cannot bet on stocks to go down by selling them short.

This model has, it appears, been savaged by a flock of sheep.

Index investing, which cuts costs by replicating an index rather than trying to beat it, has been gaining in popularity.

Active managers argued that they could raise cash, or move to defensive stocks, in a downturn.  Passive funds would track their index over the edge of the cliff.

But active managers, in aggregate, failed to do better than their indices in 2008.

So …  if you have become too frustrated to continue investing in stocks, be mindful of the fact that equity-based mutual funds have problems of their own.

As for other alternatives:  Ian Wyatt recently wrote a favorable piece about the advantages of exchange-traded funds (ETFs) for  SmallCapInvestor.com.  Nevertheless, if the stocks comprising those ETFs (and the ETFs themselves) are being traded in a “rigged” market, you’re back to square one.  Happy investing!

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