Mutual Funds: The Greatest Financial Irony in History

Can 90 Million People and $10 Trillion Be Wrong?

The word irony can have several meanings, but for our purposes let's assume it means "an outcome that is virtually the opposite of what you expected."

With that definition in mind, I propose to identify the greatest financial irony in history. It includes some 90 million people, about $10 trillion, and a circumstance that's in effect this very day. I'm talking about the mutual fund industry: the great financial irony is that "the vast majority of mutual funds are far more interested in taking money from investors than in making money for them" (New York Times, 20 April 2008). What compounds the irony is that for all the financial scandal mongering of recent years (from Enron to Worldcom to the subprime mess), this most damaging and costly injustice perpetrated against the greatest number of investors remains all but unreported.

The facts in support of my proposal are available with a modicum of digging. Candid, reliable assessments of the mutual fund industry are rare, but one excellent recent contribution comes from Louis Lowestein, in The Investor's Dilemma: How Mutual Funds are Betraying Your Trust. He explains the big-picture reasons why the mutual fund industry amounts to a deck stacked against investors, including how "management companies are independently owned, separate from the funds themselves," and that "managers profit by maximizing the funds under management because their fees are based on assets, not performance." He also notes other curious facts -- such as how the years from 1980 to 2004 saw the rate of increase in fees in stock mutual funds exceed the rate of increase in fund assets.

Other particulars in Lowenstein's book highlight how the assets of large funds will too often grow even as the performance of the fund itself either stagnates or declines. This pattern echoes the small but strong body of existing critical research, including work done by Vanguard Group founder John Bogle. He analyzed the 200 equity mutual funds with the largest money flows from 1996 through 2005, and found that those funds had average annual returns of 8.9% -- while the average investor in those funds earned only 2.4%.

There's also the Dalbar Study, which looked at investors returns for the period from 1986-2005. It found that while the S&P 500 earned 11.9% annually during those two decades, the average equity investor earned a 3.9% annual return (the annual inflation rate for the period was 3.14%).

The sum of this research is that a staggering number of investors give staggering sums of money to an industry which is built to "take" for itself, not "make" for its clients. The irony may speak for itself (if not loudly enough), yet it's also true that you don't have to be one of the sheep. You can look after yourself, and your own financial interests.