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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will be no place for restrictive practices or outdated methods on either side 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.

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