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(Author), Neil Barsky (Foreword)
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The Wall Street Journal Some Mutual Fund Numbers Look Great, but for Whom?
THE public stock markets are in the throes of one of the biggest andmost egregious financial scandals in modern history, according to LouisLowenstein. The scandal has little to do with highly publicized abuseslike market timing or insider trading. It is not directly related tothe current credit and subprime mortgage crises.
Instead, itinvolves the $10 trillion in life savings that 90 million individualinvestors in the United States have entrusted to mutual funds.
This unprecedented scandal is documented in succinct but gory detail byMr. Lowenstein in The Investor’s Dilemma: How Mutual Funds AreBetraying Your Trust and What to Do About It (Wiley, $29.95). Mr.Lowenstein is a lawyer, a former business executive and a professoremeritus of finance and law at Columbia Law School. Like Warren E.Buffett, he is a proud disciple of the “value investing” principlesoutlined by Columbia professors Benjamin Graham and David L. Dodd in1934.
Mr. Lowenstein is also a heck of an investigative reporter, as well as an astute financial adviser.
Here’s the nut of the mutual funds industry scandal, as summarized byMr. Lowenstein: “There is a profound conflict of interest built intothe industry’s structure, one that grows out of the fact that themanagement companies are independently owned, separate from the fundsthemselves, and managers profit by maximizing the funds undermanagement because their fees are based on assets, not performance.”
As a result, the vast majority of mutual funds are far more interestedin taking money from investors than in making money for them, accordingto Mr. Lowenstein.
From 1980 to 2004, the assets of stockfunds increased 90 times, from $45 billion to $4 trillion. During thatsame period, fees paid by investors and collected by fund managers viafund management companies soared from $288 million to $37 billion.What’s more, the fund managers received their fees regardless ofwhether the prices of the stocks they selected went up or down.
Not surprisingly, mutual funds continue to multiply like rabbits. Bythe beginning of 2007, there were about 4,800 mutual funds with $6trillion invested in stocks and $3 trillion more invested in bonds andmoney market funds.
“The remarkable growth is a reflection, nodoubt, of pervasive anxiety about corporate pension plans and SocialSecurity, a sense that people had better take care of themselves orthey could be left out in the cold in their so-called golden years,”Mr. Lowenstein observes.
But alas, the performance of the vastmajority of mutual funds ranges from dismal to atrocious, especially incomparison to the highly profitable performance of the managementcompanies that own them. The record of T. Rowe Price Group, which iswidely regarded as a respectable mutual fund family, is one of Mr.Lowenstein’s many graphic cases in point.
From 2001 to 2005,T. Rowe’s mutual fund assets under management soared 70 percent to $270billion; the profit of the management company that owned the funds morethan doubled. But most of the investors in T. Rowe’s five leadinglarge-cap growth funds were treading water. During the five-year periodended Dec. 31, 2005, two of the funds gained 1.26 percent and 1.38percent, barely outperforming the 0.54 percent return of the Standard& Poor’s 500-stock index. The other three T. Rowe funds postednegative returns, ranging from minus 0.26 percent to minus 2.06percent.
Mr. Lowenstein cites several structural reasons forthe failure of mutual funds to serve the best interests of theirinvestors.
One reason is that most mutual fund managers donot, as Mr. Lowenstein puts it, “eat their own cooking.” From 2003 to2006, for example, T. Rowe’s chief investment officer amassed ownershipor control of stock in the management company worth over $75 million.But his total personal investment in T. Rowe’s mutual funds was only $1million.
Mr. Lowenstein contends that most mutual fundsintentionally set low performance standards for themselves. Their goal,he says, is not to beat the S.& P. 500 average or the average of aparticular industry sector, but simply to “track,” or approximate,those averages so that their managers “don’t look bad.”
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