The Mutual Fund Industry Wealth Transfer

David Swensen, the chief investment officer at Yale University and the author of "Unconventional Success: A Fundamental Approach to Personal Investment," wrote an opinion piece on the mutual fund industry that appeared in The New York Times over the weekend. It's quite an indictment of an industry that offers products that are used by millions of investors.

In the article Swensen makes several important points:

• The mutual fund industry has failed to deliver on its promises of market beating returns. Very few actively managed funds outperform the market itself.
• Mutual funds are for-profit enterprises which means that there is an inherent conflict between their incentive to generate revenue and the investors desire to earn returns.Virtually every dollar earned by a mutual fund comes directly from its shareholders. This is a zero sum game.
• Investors are lured into buying funds that have achieved high praise by mutual fund industry monitors such as Morningstar and Lipper. Unfortunately, such recognition is for historical results. It has nothing to do with what the fund will do in the future. Academic research tells that those funds that have performed well in the past may well underperform in the future. The phenomenon is known as "reversion to the mean."
• Investors are prone to investing in hot funds only to find that they soon lag their peers. Many investors grow disillusioned, sell the once stellar fund and move on to the next hot fund. It turns out that funds often experience cycles of both superior and inferior performance. They follow each other (imagine the sine curve). Investors buy high and sell low and thus lock in results that are actually far worse than the funds they own. Dalbar has provided research on this for many years. It tells us that mutual fund investors do not come close to earning market returns. It also tells us that investors keep their funds for just over 3 years. Hardly a long term strategy.
• Swensen tells us to "invest in a well-diversified portfolio of low-cost index funds." He points out that if investors had held their funds for 10 years, their results would have improved by 1.6% per year. This is a dramatic improvement in an industry that measures performance in basis points. (There are 100 basis points in one percent.)
• Swensen also calls on the Securities and Exchange Commission to do more to regulate the mutual fund industry and protect investors.

Here's the link to the article:

The Mutual Fund Merry-G0-Round

I encourage you to read the article. I suspect those who do will find the case for Intelligent Investing - low-cost, passive investing - even more compelling.

Yesterday financial markets across the globe reacted negatively today to Standard & Poor's downgrade of long term debt issued by the United States. Last Friday S&P lowered the rated from AAA to AA+ noting that the recent budget agreement failed to address the government's debt situation. Asian markets opened down and were followed by markets in Europe and the United States.

Despite the unprecedented downgrade, the United States is far from alone in its need to address its excessive national debt levels. The European Union has several members, including Ireland, Greece, Portugal, Italy and Spain that are struggling with debt levels that are unhealthy relative to the size of their economies.

To some extent today's stock market's reaction reflects investors' dissatisfaction with the general state of the US economy. The nation is burdened with an unsustainably large debt and its elected leaders have not demonstrated an ability craft an agreement that will result in a long term solution to the problem. At the same time, economic growth is waning, unemployment remains persistently high, and inflation is creeping into the broader economy.

The stock market is a place in which investors sometimes overreact to news out of fear, panic, and desperation. Yesterday was a good example. The broad market, measured by the Standard & Poor's 500 index, dropped by over 6%. Does that mean that the stocks which comprise this index were suddenly worth less than they were last Friday? No. It means that sellers overran buyers and drove the prices of these large companies down.

Cascade Wealth Management remains committed to the time-tested long term strategies of proper asset allocation, diversification and maintaining low costs. Our clients' portfolios, while down over the past few weeks, have not suffered the temporary losses that the selloff in the U.S. stock market would imply.

What should investors do in the midst of all of this volatility? I would suggest following the advice of Burton G. Malkiel in his opinion piece in yesterday's Wall Street Journal, "Don't Panic About the Stock Market." Malkiel, professor emeritus of economics at Princeton University is co-author of The Elements of Investing, a book I highly recommend. He encourages the investors to "stay the course." So do I.

Today the global financial markets dropped rather dramatically. The Dow Jones Industrial Average fell by 513 points. The Standard & Poor's 500 index was down 4.8%

I received the following email from another investment advisory firm:

"The financial markets have been experiencing considerable volatility in the last two weeks. We have made changes to our models because we believed this could happen. We are continuing to monitor your portfolios in light of the recent economic and political events and believe the strategy we put in place is appropriate. We will continue to provide you with updates as we study the information available to us."

They believed this could happen? Well, we all know this could happen. Moreover, it happens with some regularity over the long cycles of the stock market.

The strategy we put in place is appropriate? I'd love to know what that strategy is.

Let's not forget the following:

1. The financial markets are prone to volatility. This has been the case for 200 years in this country.
2. No one knows what will happen tomorrow, next week or next year in the stock market. If someone tells you they know what is going to occur in the stock market, run in the opposite direction.
3. The stock market generally prices securities in an efficient manner. This means that identify mispriced securities is very difficult.
4. Given that the stock market is an efficient marketplace, waste no time trying to find the underpriced or overpriced security. Instead build a well allocated and properly diversified portfolio.
5. In times of market volatility, manage your emotions and not your portfolio.

Variable Annuities - Expenses Drag Performance

With the economy weakening and the stock market faltering, investors are moving out of the stock market and seeking refuge inside annuities. Morningstar reports that investors withdrew $50 billion from stock mutual funds in the 12 months through April of this year. LIMRA reported that sales of variable annuities in the United States increased to $39.8 billion in the first quarter compared to $32.2 billion in the same period in 2010.

The problem is that investors generally have no idea how much they are paying for these insurance products. According to Morningstar the average fees for variable annuities are 2.51%. Many buy a rider that offers guaranteed minimum payments. These riders cost 1.03% on average. So, investors who buy these products can end up paying more than 3.5% in expenses.

These expenses are a significant drag on the performance of variable annuities. If the sub accounts inside the annuity earned an average of 8%, the return after fees would be 5.5%. In addition, income received from an annuity is taxed as ordinary income.

Some investors would benefit from including a variable annuity in their portfolios. But the fees make them unattractive investments for most investors.