3 Reasons Not to Give Up on Mutual Funds

by Michael Fabian | August 14, 2013 9:07 am

3 Reasons Not to Give Up on Mutual Funds

Investing newcomers have been taught to expect only high fees and lackluster performance from mutual funds. Statistics and horror stories of money languishing in underperforming funds for decades while they could be in indexed ETFs is enough to make anyone run in the other direction.

However, with so much negativity emanating from naysayers and Bogleheads alike, I still believe there are a few positive attributes to owning mutual funds.

I’ll hedge that sentiment by stating that index-based investment funds and ETFs have done more for individual investors during the past 30 years than any other financial product innovation. They have ushered in a new wave of transparency, cost effectiveness and usability. Furthermore, they have allowed even the most novice investors a pathway for exposure to their investment discipline of choice, whatever that might be.

However, with all of those chips stacked squarely against actively managed mutual funds, there are three reasons you should still consider them an asset to your portfolio management approach:

Management Counts

As you perform due diligence among the many creative differentiating names that are mutual fund strategies, keep in mind that a name is just that — a name. The strategy, people and analytical talent that are behind the name is what will ultimately be the determining factor of whether or not the fund is a success.

Although paying a higher-than-average fee for active management makes complete sense if that manager can generate meaningful alpha, the truth is countless funds have fallen flat on that goal. However, asset class can be a key determination, as many managers have been able to beat their benchmarks by a fair margin for decades.

The fixed-income landscape has been a prominent example where a level of consistency of a manager’s ability to deliver outstanding excess return[1] for their investors has been proven. Fund strategies from the likes of PIMCO, DoubleLine, Loomis Sayles and Fidelity have all beat their benchmarks over respectable time frames and have offered their investors either excess income, risk management or superior security selection.

It might be more of an exception other than a rule, but with the right skill and understanding to pick the correct fund, investors can be handsomely rewarded with superior index beating returns.

Simplicity: Not Always Best

Although I’m inclined to agree with Leonardo da Vinci’s less-is-more philosophy, when it comes to investing, that might not always be the case.

Building on the notion that active management can be a very compelling reason to own a fixed-income vehicle in the form of a mutual fund vs an ETF, many of these funds engage in a sophisticated approach that cannot be replicated in the form of an ETF due to regulatory challenges.

The use of futures, swaps, options or other inverse strategies are tools that active fund managers employ to control existing holdings or seek out alternative opportunities. I won’t further the debate of whether they’re effective portfolio management tools in every market, but I will say they often allow managers to increase or reduce risk and exposure within a portfolio more dynamically, or for a shorter time frame than would otherwise be efficient. Excellent examples can include mutual funds that adapt to changes in the interest-rate cycle, such as we are experiencing right now[2].

Owning one of the aforementioned funds would insulate an investor’s risk to declining bond prices, thereby overcoming a common pitfall of passively managed strategies.

The ‘Flash’

I remember May 6, 2010, like it was yesterday. I think every active portfolio manager using ETFs remembers that day.

Voltaire’s ominous quote describing the anatomy of a lightning bolt probably sums it up the best. As flashes of red began to touch down in the derivatives market, a thunderbolt of selling extended thought the entire investment landscape. Bid/ask spreads on even the most unshakable, stalwart stocks widened to levels that sent investors with automated stop-loss protection over a cliff, without them even knowing it. ETFs with net asset values in the 20s or 30s saw trades flow through at just 1 cent.

It was an investor’s worst nightmare that later became known as the “flash crash,” and with automated trading systems still making up a strong share of daily trading volume, I doubt it will go down in history as a one-time event.

Naturally, the one type of fund unaffected by the many trading glitches was the one that trades only once per day, and not during market hours — the open-ended mutual fund.

After stocks had regained their footing during the latter stages of the trading day, all that were affected were those ETFs that traded off their respective net asset values. Granted, had you not had automated stops you could have emerged just fine, but ETFs have gone through other periods where they haven’t been able to maintain a tight tracking margin. That’s something that all ETF investors should heed caution to, but something mutual fund investors needn’t fear.

Michael Fabian is Managing Partner and Chief Investment Officer of Fabian Capital Management. Get more investor insights from Fabian Capital, visit their blog[3].

Endnotes:
  1. outstanding excess return: http://fabiancm.com/206/
  2. such as we are experiencing right now: http://fabiancm.com/5-funds-to-buy-for-rising-interest-rates/
  3. visit their blog: http://fabiancm.com/investor-insights/blog/

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