Is It Time to Rethink Your Mutual Fund Picks?

Why investors trade too often and for the wrong reasons.

By SHARE

Retirement investors are at one of those crossroads they'd rather never see. What should they do with their money? Stocks are taking a beating. So-called "safe" investments—government bonds and bank certificates of deposit—are yielding minuscule returns. The economy is weak here and in Europe. Washington seems incapable of leadership.

Virtually all retirement experts say investors should hang in there and not bail on the market. Stocks recovered after their collapse in 2007 and 2008, experts say, and they'll recover from this drop as well.

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Comforting as that advice may be, it flies in the face of big mutual-fund withdrawals in recent weeks. Lots of people, it would seem, are not staying the course. They are moving out of the market or at least reducing their exposure. Whether they are cutting short their losses or selling at the worst time remains to be seen.

If hanging in there is rule No. 1 from the big retirement fund companies, rule No. 2 often is: Don't try to time the market. Even professionals lose at this game, and individual investors shouldn't even try.

Whether you have decided how to handle your investments or you're still struggling with the challenge, David Swensen has some provocative advice. Swensen is chief investment officer of Yale University and has had a magical investment touch with Yale's big endowment. He also is a harsh critic of the mutual fund industry.

Most people invest in stocks and bonds through mutual funds and exchange traded funds (ETFs) as opposed to individual stocks. There is literally a gaggle of funds for every investment appetite. And there are big investment companies spending a lot of money to advertise their funds as the best choice.

In doing so, Swensen says, they are acting in their own interest, but perhaps not in the interest of investors in their funds. They are generating big transaction fees for themselves by convincing investors to sell and buy funds more often than they should. And they are being aided by an unlikely source—Morningstar, the dominant scorecard keeper of fund performance through its influential five-star rating system.

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"Mutual fund companies, retail brokers and financial advisers aggressively market funds awarded four stars and five stars by Morningstar," Swensen wrote in a recent OpEd piece for the New York Times. "But the rating system merely identifies funds that performed well in the past; it provides no help in finding future winners." Over time, funds naturally migrate to different star-ratings categories, reflecting inevitable rises and falls in performance. Buying a five-star fund hardly guarantees superior returns.

"In 2010, investors redeemed $152 billion from one-star, two-star and three-star funds and placed $304 billion in four-star and five-star funds," the article continued. "In the crisis-scarred year of 2008, even as investors withdrew $174 billion from one-star, two-star and three-star funds, they added $47 billion to four-star and five-star funds. Year in and year out, flows to four-star and five-star funds prove remarkably resilient and overshadow flows to the three bottom categories."

If investors had instead followed the buy-and-hold advice that they regularly receive, their returns would have been much higher. Churning among funds not only cost them returns, but also boosted transaction fees to the fund companies doing the advertising.

Swensen went on to criticize the mutual fund industry for poor consumer disclosure practices and also had some invective left over for government securities regulators, who he claims have failed to regulate or protect consumer interests. Not surprisingly, his views are not winning hearts and minds in the mutual fund industry.

Says the mutual fund industry's primary trade group, the Investment Company Institute, of Swensen: "He consistently ignores or is unaware of basic facts about how mutual funds operate, how investors seek and use funds, and how individuals manage their portfolios," ICI chief economist Brian Reid said in a lengthy response to Swensen's OpEd.

[See Solid Dividend Stocks Remain Investor Refuge.]

"The heart of his argument is that the mutual fund industry somehow colludes with individuals' brokers and investment advisers to induce investors to 'churn' their funds, driving cash toward the highest-cost funds," Reid wrote. "How well is this alleged scheme working? Not at all, if the data on net new cash flow to stock funds is any indication. From 2000 through 2010, 82 percent of that new cash went to stock funds whose expense ratios were in the lowest quartile. Even among actively managed funds, 74 percent of net new cash went to the 25 percent of funds with the lowest expenses. Those figures suggest that the mutual fund industry is far more competitive—and that investors and their advisers are a lot more thoughtful and fee-conscious—than Swensen appears to believe."

Morningstar also differed with Swensen's view of how investors use its star rating system. "People don't get hurt by selling 1-star funds and buying 5-star funds," Morningstar's vice president for research John Rekenthaler told U.S. News. "They get hurt by buying hot categories and selling low categories. hey buy tech in 1999, sell in 2003, get hammered. Buy stocks in 2007, sell in 2009, get hammered. Buy bonds in 2009, miss the stock rally for the next two years."

"You know that's how mutual-fund investors hurt themselves, I know that, Swensen knows that," he continued. "The stars don't tell what category that people should invest in. There's no way that anybody could make such a claim; it's simply not defensible."

Morningstar does not strongly defend its ratings as being able to predict future investment results. But Rekenthaler says they do have some "modest" predictive value for long-term investors. Morningstar announced in June that it was developing "analyst ratings" that would reflect investment analyst's qualitative views about the future performance of investment funds.

Morningstar said the new ratings would begin appearing in the fourth quarter on 150 to 200 larger funds with heavy investor interest. During 2012, it said, it plans to provide analyst ratings on roughly 1,500 funds representing 80 percent of total fund investment assets.

Twitter: @PhilMoeller