Mutual fund companies have largely opposed any attempts at fee reform, increased transparency and adopting a fiduciary standard. Any of these reforms would address the issues related to conflicts of interests between investment product sales professionals and their own customers.
While the conflict of interest problem was addressed in 1973 by the Employee Retirement Income Security Act (ERISA), which covered pension plans and subsequently, 401(k) plan administrators and service providers, it was never applied to the larger retail sales side of the business.
However, individual investors do still have some power: You can hire and fire mutual fund and money managers. Outside of your 401(k) plan, there are about 7,600 mutual funds and over 800 ETFs from which to choose.
To help cut through the financial product clutter, here are three basic criteria to make your selections easier.
1. Avoid investing in sub-advised managers.
Mutual fund companies commonly make third–party arrangements to sell funds under another name. This sub-advisor arrangement is the equivalent of private labeling in the retail business, and while the quality may still be there, the costs may be different. It’s best to buy directly from the fund company which employs the fund managers.
Many companies that sell 401(k) plan services offer mutual funds as part of their total plan administration package. The problem is that these companies are in the plan administration business first, and the money management business second. One large West Coast insurance company has an entire family of funds which are 100% sub-advised. It then becomes incumbent on the fund company to show if its sub-advised funds have lower expenses than if the 401(k) plan administrator could buy directly from the investment management firm. But many 401(k) plan participants often have no choice in determining the latitude of their fund selections. If your 401(k) plan only offers sub-advised funds, ask for more choices.
2. Avoid insurance company mutual funds.
This may be more controversial, but insurance companies have huge overheads (primarily in sales, marketing, and administration). While the future performance of any given fund is unknown, expenses are the most important thing an investor can control. And heading into the lower-return investment environment in 2011, it’s critically important to manage expenses.
The Department of Labor has identified 17 fees that investment companies charge shareholders. While some costs are well-known (administrative fees, for example), there are also hidden costs, such as trading expenses, which can easily double expenses. Since most investors don’t even know they exist, such fees can “invisibly” erode shareholder returns. Princeton University finance professor Burton Malkiel estimates that fees of just 3% can devour up to 50% of investment returns.
Insurance companies sell funds through expensive national sales networks, which are supported by layers of sales managers and executives. Most of these sales expenses are supported by shareholders in the form of 12b-1 and other fees. These large networks also engage in revenue-sharing deals between the fund company and investment professionals who buy the funds. This is one main cause of conflicts of interest –and the resulting clamor for investment sales professionals to adopt a fiduciary investment standard.
Unfortunately, most investors are unaware of these behind-the-scenes practices, but it explains why no insurance company is in the discount mutual fund business.
3. Avoid funds which have changed managers.
While some fund companies use a team approach to fund management, others have used single managers, some of whom have built up impressive, long-term track records. When a manager leaves, due to retirement or poor performance, it raises questions about whether the talent is leaving with the fund manager — or whether the fund will repeat the successful fund performance in the future.
Unfortunately, most investors don’t know that answer. Unless the fund company goes to extraordinary lengths to provide an explanation for their manager succession plans, move your money.
In many cases, manager contracts contain specific language a fund company must use when replacing an outside manager. For instance, they can’t say a manager was “fired” — they’ll often just announce a new manager was hired, with a closing sentence saying who they replaced. In many cases, fund companies have been criticized for not replacing a faltering fund manager quicklyenough.
Another related problem occurs when managers are fired and then replaced by new managers who fail to deliver excess returns above the benchmark.
In one study of 3,700 plan sponsors from 1993 to 2002, managers who were fired went on to deliver “excess returns [that] would be larger than those actually delivered by newly hired managers.” The study concluded: “We find that if plan sponsors had stayed with fired investment managers, their excess returns would be larger than those actually delivered by newly hired managers.”
While this raises new questions about manager turnover, some investment professionals say it also buttresses the case for passive management.
