Summer Journal 8/26: Problems with Mutual Funds/ETFs
During my job this summer I kept a notebook and wrote about 3-5 pages of notes each day. The thing is about 200 pages front and back and I got to about 170 by the end of it, so there’s a shitload of my thoughts on paper. It’s funny reading some of the earlier notes compared to my later ones. One of those things where you go into the summer thinking “alright I know a solid amount let’s crushingtons”. Then you end the summer and all you can think is “wow I learned so much… and I didn’t know DICK coming in”. But ya I’m gonna start posting some of the better notes I took and maybe see if my opinion has changed since.
This note is from one of my last days when I was having a conversation with my boss about different types of careers. We started talking about mutual funds, and how they differ from say, a broker like him. To preface, my boss is an extremely hard worker, the kind of guy who gets 4 hours of sleep a night because he’s got trade strategies running through his head non-stop. More than that, he’s extremely old school. Doesn’t pay attention to P/E ratios or any technical indicators like that. And to his defense, he’s good as HELL at what he does… making money for other people. But back to my main point, he has a strong anti-mutual fund opinion. And here’s why.
Let’s say you want to get into bonds right now. While there are tons of strategies you can use for bond exposure, the two most basic are buying your own bonds straight up or investing in a bond fund. For most people, the latter means your broker will purchase shares in whatever bond mutual fund it is you want. Right off the bat you should notice something. You’re paying a broker to manage your money, but the asset you hold (shares of the bond fund) is being managed by someone else entirely. Seems stupid to me at least.
The next issue is the mutual fund managers’ motives, which have to be tilted toward the fund investors. Most investors who want to get into a bond mutual fund are curious about one thing: what is their yearly return? When you buy your own bond(s), you know the YTM, call protection status, maturity date, etc. All of these things let you know exactly what your total return is, not just what your coupon rate is. If you’re not following, this is what I mean. An investor buys into a fund because he sees it gives a 5% semi-annual return, in other words the fund’s structure is made up of 5% coupon bonds that pay every 6 months. This sounds great to the investor, but the actual return isn’t going to be 5%. If all the investors care about is that 5% coupon, the managers will have no problem paying premiums on those bonds when structuring the fund just to get that 5% coupon (not a 5% YTM). So in reality, when you sell your shares or the fund closes you won’t be making a total return of 5%/6-months.
The last part shows how mutual fund management can be bad (obviously there’s a ton of good mutual funds out there with great managers, but I’m speaking in general right now). The main goal of the fund is that % return, while brokers and FA’s must also worry about their clients retirement goals, whether or not they need to send kids to college, etc. So, mutual fund managers can apply one single strategy to every investor, whether or not that strategy applies to that investor. The managers don’t have to speak directly to the investors, and only have to worry about the structure of the fund (making sure they’re solvent enough to pay out investors who want out). In the end, mutual fund managers don’t have too much incentive to actively manage the fund for higher returns. They know that they can load up on coupon bonds paying out what people want, and that’s good enough. I’ll expand on that point in my next post.
The last problem goes back to the fund structure. Money is always coming in and going out of these funds. Therefore, the structure of the fund is always being changed (i.e., diversification %, maturity structure, etc.). Unlike a broker, where you know exactly what you hold at all times, it’s much more difficult finding out the funds exact holdings, and therefore your own holdings (as a % of the fund). All in all, it’s a pretty lazy way to invest your money. There are plenty of ways to find higher returns, more income/cash flow, or whatever your personal strategy should be.