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Private and Confidential

The Endgame For Mutual Funds

By Doug Fabian, Editor, Successful Investing - from John Mauldin's e-newsletter.
"The Britain that is going to be forged in the white heat of this revolution 
will be no place for restrictive practices or outdated methods on either side
of industry."
---Prime Minister Harold Wilson

History is replete with examples of good ideas that have outlived their
usefulness. For example, the horse and buggy, the homing pigeon and the
hourglass are just a few that instantly pop into my head. Indeed, even such a
relatively recent invention as the typewriter has given way to the vastly
superior word processing powers of the personal computer. Someday the keyboard
and the personal computer will seem quaint. All of these inventions served
their purpose well in their time, but they were all eventually relegated to
the scrapheap of history in favor of better, more efficient forms of
technology.

But technological development isn't the only area where ideas outlive their
usefulness. The principle of constant change holds true in most walks of life,
and the investment arena is no exception. Remember what life was like trying
to invest before the existence of mutual funds?  What about those exorbitant
government-mandated commissions charged by brokers in the 1970s? How about not
being able to look at your account online or make a trade instantly using the
Internet?  Yes, my friends, change is constant in the investment world too,
and in my opinion, we are about to experience another big change with respect
to what kind of investment vehicles we'll be using.

Until recently, I always recommended no-load mutual funds as the "weapon of
choice" in the battle for market-beating investment returns to subscribers of
my Successful Investing newsletter.  In fact, for over 27 years I've been one
of the staunchest proponents of no-load funds as the primary investment choice
for the individual investor.  But times change, innovations arise, and what
were once good ideas begin to outlive their usefulness. So it is with mutual
funds. The once favorite sons of investment portfolios worldwide are now in
danger of going the way of the typewriter.

Now I know what you might be thinking about now.  How can an investment
vehicle with over $6 trillion in assets, 40 million shareholders, and over
10,000 choices now be obsolete?  Well, the answer is that while mutual funds
are not quite dead yet, they are starting to become out of favor with
investors, and for a number of very good reasons.  First let's examine some of
those reasons, and then we'll take a look at my new favorite alternative to
mutual funds

The Best Place To Be Until Now   For several decades no-load mutual funds were
by far the best way to get broad-based exposure to the market at a reasonable
cost.  In fact, when the ability to make changes to your mutual fund holdings
via telephone first came about in the mid-1970s, my father saw this as a way
for the individual investor to become empowered and take control over their
own portfolio.  He felt so strongly about this new potential for personal
investor empowerment that he started the Telephone Switch Newsletter, the
predecessor to what is now Successful Investing.  Back then the no-load fund,
and the ability to switch your holdings with a simple phone call were the
state-of-the-art investment tools for investors.  Now, most of us use the
computer and the Internet to accomplish this task, however, we're largely
still using the same type of fund structure we did in the 70s.

The question now is, why are mutual funds no longer the place to be?  What's
different now?  Why are funds no longer the darlings of the investment world?
Let's take a look at a few of the answers.

Scandals:  A funny thing happened about 10 months ago. The public caught wind
of the secret after-hours deals available only to favored mutual fund
investors that cheated long-term shareholders out of profits.  "The world
changed on Sept. 3, 2003," said Jay Baris, an attorney who works with the
mutual fund industry in a recent Wall Street Journal article.  He was speaking
of the day New York Attorney General Eliot Spitzer unveiled his investigation
into improper mutual fund share trading.

Since news of the fund scandal broke, investors have been questioning the
trading practices of many of the most prominent mutual fund companies. They've
seen many of their favorite fund companies come under attack and be fined and
reprimanded by the SEC for improper trading practices. Until the scandal no
one really realized that their personal net worth was being negatively
impacted by the behind-the-scenes privileges of a few big players that the
fund companies were eager to please at individual investor expense. The
scandal got people to question what the fund companies were doing in their
name.  During this period of questioning people began to look at what they
were getting for their money.  Over the past five years, investors realized
what they were getting wasn't very much at all.

Underperformance: A great number of investors have come to realize that
although their portfolios haven't made a great deal of money over the past
five or so years, the fees they have consistently paid for the privilege of
that underperformance have been omnipresent.  We'll get to those outrageous
fees in a moment, but let's first stick with underperformance.

It is my contention that the mutual fund industry as a whole does a terrible
job of managing money in a bear market.  One reason for this is obvious. The
fund companies want you to buy and hold their funds, and therefore they won't
ever tell you to sell!  Think about it, when was the last time you heard of a
mutual fund company advocating the sale of one of their funds because the
market was just not the place to be?  I can't recall ever hearing that.  Now
there may be a few talented brokers out there who will try to get you to
rotate from one market sector to another given conditions in a specific market
segment, but brokerages and fund companies don't want you to sell.  They want
you to continue to blindly pump your dollars into their company so that they
can grow their assets.  Most of the time, growing your assets is not their
first concern. And of course, the last thing they want is to lose your assets
via a sale of one of their funds.

Now before any of John's learned readership takes me to task about the
difficulty for virtually everyone over the past five years to make a profit in
this market, let me first say that I agree that these past five years have
been challenging for all of us in this business, myself included.  But here's
the rub, the fund companies are making money by charging high management fees
despite bad performance results.  Think about that in your own profession, or
any other profession. If a salesman were to fail to meet his goals over a five
year period, would he still receive the same fees and commission than if he
were to double his quotas?  Not likely, unless of course he was a mutual fund.

As part of my Successful Investing service I publish a list of funds I call
The Lemon List.  This quarterly list flushes out the funds that have
underperformed their peer averages for the past 1, 3 and 5 year periods. It's
kind of a who's who of fund industry losers, underachievers and over
chargers.  The worst of the worst as it were.  This is where you'll find some
of the most egregious violators of the high-fee for underperformance school of
thought.  You can get this list for free by registering at
http://www.fabianlive.com/register.jsp.

Now, speaking of fees, that brings us back to just how much investors are
paying for the privilege of that underperformance.

Fees: Now for the real killer, and what I think will ultimately bring about
the obsolescence of mutual funds, high management fees.  In the bull market of
the late 1990s, people tended to pay only modest attention to the fees levied
by mutual fund companies.  After all, what difference did it make if you
gained 20% in a fund and paid a 2% management fee?  You were still ahead of
the game by a whopping 18%.  For a couple of years there, those kinds of
returns were the norm.  But as we've already mentioned, change is a constant. 
What was once commonplace is no longer the norm, and so it is with double-
digit mutual fund returns.  Let's face it, in a bull market virtually anyone
with a pulse can make money, and even average fund managers were able to do
very well for a lot of shareholders.

So far in 2004 nearly all fund categories are down for the year.  Of course,
that hasn't stopped fund companies from continuing to charge their management
fees.  According to Morningstar, the average actively managed mutual fund
charges expenses of 1.56%.  That fee is rain or shine, up or down market, win
or lose at the end of the year.  While this may not seem like much on its
face, consider that when you purchase an average fund you are already in
nearly a 2% hole that you have to then climb out of in order to be positive at
the end of the year.  With performance so far in 2004 largely in the red, that
near 2% starting deficit could mean the difference between a profit and a
loss.

The problem of high fees gets even greater if you are buying B-shares from a
fund company or brokerage.  B-shares are a class of mutual fund shares that
charge investors a commission only when the shares are sold.  Unsuspecting
investors fall for this fee structure by being told that they can put all of
their money to work right away, with no up front fees.  What fund companies
don't tell you is that they then charge higher continuing fees to cover the
cost of advancing the commission to the broker or agent that sold you the B-
shares originally.  Because of these higher fees, investors can end up earning
far less money on their investments than they would have if they had just paid
the management fee up front when they originally bought the fund.

It should be clear to you by now that I think investors have been taken
advantage of by advisors advocating a buy-and-hold strategy, charging
exorbitant management fees and delivering weak fund performance.  All of this
has helped make mutual funds yesterday's investment of choice. So where should
the smart investor go now? My choice is Exchange Traded Funds, or ETFs.   The
ETF Revolution

Like the automobile, the clock and the personal computer, Exchange Traded
Funds or ETFs, are an idea whose time has come.  Indeed, it is often said that
there is no force so powerful as an idea whose time has come, and that's
precisely how I feel about ETFs.

What are ETFs? For those of you still not familiar with them, ETFs are sort of
the best of both worlds.  They offer you the exposure to both broad market
indices (such as the Dow and S&P 500) as well targeted market sectors like
energy and basic materials, yet they trade like a stock on an exchange (most
trade on the American Stock Exchange or AMEX), which means you can buy and
sell them anytime during market hours. With mutual funds there is a one-day
delay when you buy or sell, and then you are forced to accept the closing NAV
of the fund as your buy or sell price.  Using ETFs your decision is automatic
and you know what price you've bought or sold at moments after you execute
your order.

This is particularly important in a tough market when each day could mean the
difference between a gain and a loss for the year.  Currently there are over
120 ETFs to choose from, including ETFs that cover the bond market.

Recently I recommended that subscribers to my service move 100% of their
portfolios into cash. Because I am what is known as a trend follower, I am in
the market when the trend is up, and out of the market when the trend is
down.  I base my decisions on the price movement of a proprietary market
indicator that represents a cross section of the entire market.  My indicators
told me that it was time to play it safe, wait on the sidelines until
conditions merit a return into equities. Because I may get these "Buy and
Sell" signals several times in a year, I only recommend to my readers
investment options with low fees and few holding period penalties. ETFs offer
all of these benefits, and at a fee structure far more attractive than mutual
funds.

While the average mutual fund's management fee is 1.56%, ETF fees can be as
low as 0.1%.  In fact, the average ETF's management fee is just slightly
higher at 0.36%.  Compare 1.56% to 0.36% and that's a real, in your wallet
difference at the end of the year, especially when you're dealing with big
numbers. 

Another thing I like about ETFs is that they are objectively managed.  For the
most part, ETFs are tied to the indices in the major markets.  As the Dow
goes, so go the Diamonds.  As the S&P 500 goes, so go the Spyders. [The ticker
symbol for the Dow ETF is DIA, the S&P 500 is SPY and therefore explain the
nicknames Diamonds and Spyders - John]  This makes it easy for anyone to keep
track of their investments simply by checking up on the major market indices. 
You can invest in country indexes, specific industry indexes and more.
Simplification and savings, two ideas that will never go out of style.

Remember that scandal we talked about earlier?  Well, one pernicious effect it
has had on mutual funds, and in particular for trend followers like me, is
that fund companies are now waging an aggressive campaign to lock investors
into buying and holding all mutual funds.  Most mutual funds are now levying
very stiff redemption fees if you take your money out within a given time
frame. This new fee is just another reason why I'm convinced mutual funds are
headed for a fall.

You can track ETFs, and learn more about them at http://finance.yahoo.com/etf
and at www.amex.com.

The good news here is that everything beneficial about a mutual fund can be
obtained by using an ETF, and with virtually none of the downside.
Significantly lower fees, no trading restrictions, instant trade execution and
objective management tied to the market itself.  It's a powerful idea whose
time has come. Now lest you think I am the only one out there touting the
benefits of ETFs, don't take it from me, take it from the fund companies
themselves.  I recently read a story in the Wall Street Journal that talked
about how more and more fund managers were buying ETFs to get exposure to
different market sectors.  If fund managers are using ETFs to bolster their
funds, why can't the individual investor just bypass the fund manager and buy
ETFs on their own?

In my opinion the likely outcome of everything I've touched on here is that
investors are likely to move into ETFs in greater and greater numbers in the
years ahead.  Many more ETFs are being registered each year, and their growing
popularity is an unstoppable trend in the investment world.  I think that what
you'll likely see is massive mutual fund redemptions with a re-allocation into
ETFs.  I also think there will be a move into the less regulated field of
hedge funds by high-net worth investors in the years ahead as well.  I will
defer to the hedge fund expertise of this site's host for more on that subject
however.

Finally, I would like to thank John for allowing me to present my "thoughts
from the frontline." I've been a big fan of John's work for years, and I
really appreciate this opportunity.  Also, big congrats on the stellar New
York Times book review.  I know first hand how good it feels to get a positive
review on your book.  When I wrote my book, Maverick Investing, the best part
was reading the positive feedback I got from critics.  So congratulations once
again on a very well deserved positive review.


This report has been prepared for information purposes and is not an offer, or an invitation or solicitation to make an offer to buy or sell any securities. This report has not been made with regard to the specific investment objectives, financial situation or the particular needs of any specific persons who may receive this report. It does not purport to be a complete description of the securities, markets or developments or any other material referred to herein. The information on which this report is based, has been obtained from publicly available sources and private sources which may have vested interests in the material referred to herein. Although GRI Equity and the distributors have no specific reasons for believing such information to be false, neither GRI Equity nor the distributors have independently verified such information and no representation or warranty is given that it is up-to-date, accurate and complete. GRI Equity, associates of GRI Equity, the distributors, and/or their affiliates and/or their directors, officers and employees may from time to time have a position in the securities mentioned in this report and may buy or sell securities described or recommended in this report. GRI Equity, associates of GRI Equity, the distributors, and/or their affiliates may provide investment banking services, or other services, for any company and/or affiliates or subsidiaries of such company whose securities are described or recommended in this report. Neither GRI Equity nor the distributors nor any of their affiliates and/or directors, officers and employees shall in any way be responsible or liable for any losses or damages whatsoever which any person may suffer or incur as a result of acting or otherwise relying upon anything stated or inferred in or omitted from this report.

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