Read of the Day: How the Mutual Fund Industry Eats Your Lunch

I’m not the first to predict the death of the mutual fund industry.  But it’s coming….Here’s why:

The mutual fund industry dines off your ignorance. It has created a structure where the fees charged to run mutual funds include a very large chunk that is directed by fund companies to advisers who sell funds and their firms. All fund fees are scooped off the top of fund returns, and the net amount is what appears in fund company literature and on third-party data websites likeGlobeinvestor.com.

The fund industry turned advisers into their sales arm, and rewarded them with a compensation system that kept inattentive investors from ever encountering fees. But advisers sold their souls in this transaction. In allowing people to think there’s no cost to advice, they made it possible to also think there’s no value to it.

Read more here.

Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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  • Johnny Evers

    That’s not quite right. Mutual fund fees are pretty easy to find and very widely discussed.
    Most people understand that if they own Vanguard or Franklin Templeton or Pimco mutual funds that the managers are not working for free and their advisor is getting a share, too.

  • Stephen

    The UK is a decent role model for how this is changing.

  • Geoff

    Another interesting point is that even within a mutual fund company, there competing interests. The portfolio managers, most of whom are compensated based on performance net of fees, are always pushing for lower fees (the lower the fee, the higher the net return). So the PM’s are very much aligned with the end client. However, the marketing/sales people and the senior execs are usually more interested in profits and AUM, and thus get into bed with the advisors.

  • http://None Midas II

    My Vanguard funds display their fees up front. No surprises, and their people work for salaries, not commissions. Outside advising sources are included in the fees, so nothing unexpected happens. The results are average, but the funds are often indexes. You won’t make a killing, but are less likely to lose your shirt. Slow but steady in a balanced portfolio has been quite good for us.

  • Cowpoke

    Easing PRE-tax invesments laws would go a long way.
    I would like to be able to pay an adviser a one time fee to look over a portfolio I build myself and advise based on certain conditions.
    That’s it.

  • Johnny Evers

    Cowpoke, there are financial advisors who use that model.
    Also remember that if an advisor is properly doing his job, the investment side of things is just a small part of what the client needs. He should be offering to help with planning, budgeting, debt management, tax questions, estate planning and more.

  • Cowpoke

    True dat. But I would like to be able to take at least 6% of my income pre taxed to invest how I see fit, not just through mutual fund IRA’s or 401 K type vehicles.
    I would like to purchase a property for rental income. Are there ways to do this with pre taxed income?

  • Tom Brown

    I find the idea that the death of the mutual fund industry is coming, especially for low cost index funds, to be hard to believe. Geez… I pay what… 0.06% on the Vanguard 500 fund (I think it’s the class beyond admiral.. because it’s through my 401k… “institutional investor” maybe?). How can you beat that? That comes to $540 a year for a $900k investment. But that extreme low cost end of the spectrum does have competition.. I think Fidelity (our old 401k company) had a S&P500 index that was cheaper than Vanguard for a time… .and there are others. Plus there’s so darn many of those index funds now… you can get very specialized (for the cost of higher fees… but still pretty low). And those funds, as I understand it, form the basis of the exchange traded funds (at least at Vanguard)… a game I played for a while, but I got tired of trying to keep on top of all that… I prefer to park my money for long periods of time (a year or more) w/o having to keep on top of it and “rebalance” or change things around, and for that low cost index funds are great. Plus, if you do the mutual fund directly (rather than the derived ETF) you actually pay less (I thnk!)… so if you’re not going to day trade, why do the ETF? The only advantage I can see is if you want to have the security of knowing that you can pretty much sell everything immediately in real time if you want… there’s like at least a 24 hr delay with mutual funds, and you have no control over the exact timing.

  • http://www.orcamgroup.com Cullen Roche

    Maybe death of certain parts of the mutual fund industry….There’s what, $25T in global mutual funds just waiting to find a home in other products once those investors realize there’s no value add in many of those funds….

  • Tom Brown

    … oh, and I guess you can set up “limit” buys and sells to automatically sell when triggered by price events… which is kind of cool. I’ve been resetting to sell my small investment in SLV (silver fund) when it gets to the price I paid for it (I have to redo this every 60 days because the order expires), for about a year and a half now! Once that happens (which may be NEVER!) I will have sold the last of my ETFs.

  • Tom Brown

    OK, … I can see that. I never put much in “managed funds” and I haven’t done it for about a decade now! It’s hard to swallow paying 2% or 1% or even 0.5%… and it gets harder and harder the more you save (just work out what it costs for that “expert” help… and it’ll scare you! At least it scares me).

  • Tom Brown

    This chore, every 60 days, serves as a good reminder to myself why I should stay out of ETFs! (and why I shouldn’t speculate on “precious” metals!)

  • Tom Brown

    I thought of that too… My 401k management company (it used to be M&I, but they were bought out) allowed you to set up a brokerage account. Also, my Vanguard IRAs allow you to set up a brokerage account (which is a really good deal! I don’t recall the cost per trade, but it’s small.. no more than $2… maybe even free once you get a certain amount saved up… I don’t recall). I don’t use it anymore, preferring more boring investments. However, I was wondering if I could somehow set up my own company, … that I could invest in through these brokerage accounts, and then do what I wanted with the funds (like go to our local Indian Casino and bet it all on red). Hahaha!

    Also, you know you can roll over an IRA by having the check sent to you directly. Then you have 60 days to put it back into another IRA. I looked into that… (again… take the money, head to the casino, etc.) … more for fun than anything else… but there are some road blocks… I don’t recall what they were, but whoever set up that rule thought about my that kind of reckless behavior and tried to patch those loopholes.

    Many 401k arrangements allow you to borrow up to $50k from your funds… which I’ve used several times now, including on real-estate… which ultimately proved to be a mistake :(

    The good part though is you pay the interest back to yourself!

  • Tom Brown

    I believe that the way John Bogle set Vanguard up in the first place is that the funds themselves own the company! So it operates more like a co-op than a for-profit company. I think it’s still like that.

  • Anon

    Not in Canada, if you wanted to know how much your advisor is being paid from the mutual funds they are from the funds that they are sold. They have to dig through the prospectus to find this out. Overall MERs are easily available though. That’s why there’s new regulations coming in that will force all advisors/firms to clearly state how much commissions their advisor is being paid.

  • Anon

    Not always the case, some PMs are compensated on performance, some PMs are compensated on total AUM and some a mix of both. Fidelity pays stricly based on performance for the most part but other firms vary from only performance to only AUM.

  • Tom Brown

    I wanted a service like Cowpoke describes, so I went to a guy my accountant recommended, but I wasn’t happy w/ the service he described. I think he was from “Ameriprise” or something like that. I got the idea that he wasn’t going to be a big help advising me on my real-estate investment options (these were investments I already had), and it wasn’t a one-time thing model. He was talking about putting my money in commodities (which I wasn’t interested in) and that he’d HAVE TO (by law!) move my money around on a regular basis. That completely turned me off, and I never went back.

  • Boston Larry

    Tom, Try a fee-only financial planner who makes no commissions on what he recommends for investments. Look for CFP’s in your area.

  • Cowpoke

    Tom, sounds like your trying but the LAW is hindering progress.
    With housing so low and Exuities so high, why not let people use thier 40xxx Investment vehicles to purchase residential housing?
    This would serve multi purposes and be a good thing I think.

    I would like to purchase a home in Airizona that I could rent out for retirement income.

    I would like to use 6+% of my income PRE tax to do this with. I would also like the ability to cash out of 401K style plans to either wholy fund or down pmt.

    This helps me for future and helps distreassed housing mkt now.

  • Geoff

    Right. I know one PM who receives a portion of the MER directly, which I suppose is like a quasi-AUM based approach. Not sure how common that is, though.

  • http://www.deltafinancials.com Delta Financials

    The big question is how there can be a genuine value add in numbers as big as those. We can’t all win at this game, simultaneously – so, with a number that large…!

    I think there’s a real need for a very different incentive structure, though!

  • KM

    You might find a custodian for an IRA that would allow you to do that, but the question is why, when you would give up the deduction for rental-related expenses, not to mention the depreciation? How would you pay for something like roof repair if you did not have the cash in the account? It cannot come from outside the pre-tax account.

  • ES71

    Not all 410Ks are created equal.
    Our 401K doesn’t let yo borrow more than 10% of the balance.
    In addition , even if the company allows you to open a brokerage link account they still control what you can buy in that brokerage.
    OUr company only allows mutual funds in the brokerage account, no individual stocks or ETFs.

  • Cowpoke

    KM, are you saying that deduction for rental-related expenses are pretty much like pre tax dollars anyways?

  • Mike Bell

    As someone who has been selling mutual funds for over 20 years, and had many moral problems with it (I did the best I could for my clients given the limitations of the industry which are in no small part due to the government), I think I can offer some insider insights. Here in Canada, mutual fund management fees are insane. We only earn a small part of that management fee. Advisors must belong to dealers. The dealers take a good chunk of any and all commissions. But the lion’s share of the fee is going to the fund company. So don’t think I’m sticking up for my industry or business. I’m not. In fact, I’m getting out of the business very soon. That having been said, the article is ridiculously biased and full of errors/lies.

    To suggest that clients are unaware of the management fees and trailer fees is absolutely wrong. No other industry faces the scrutiny and disclosure requirements that we do. In the coming year, there will be additional disclosure regulations making the management fees and trailer fees appear on the client’s statements! When you go to the dentist, have surgery, buy a car or a shirt, do they disclose to you what they are earning on that product or service? Nope. While it is true that most of these investors. But what are their alternatives? Decades ago, they were getting hosed by whole life insurance policies and fixed-income shaving. For many people, mutual funds can be a good product. Most people will make huge mistakes without an advisor, as we all know that most human beings’ brains are wired to fail at investing. Also, depending on the product and client’s financial situation, there are certain tax advantages that are not available via other types of investment vehicles.

    The ignorance of most clients re: mutual funds is not about the advisor commissions nor the fees. Most clients aren’t fools. They know they are paying a fee for service. It’s the lousy performance! It’s the fact that the vast majority do not (and cannot) come close to the index performance, i.e. the so-called professional money managers are not worth it in most cases. Beta less the fees (at best). Add to that the fact that the major equity markets have performed horribly for more than a decade now.

    I would much prefer if fees were charged directly to clients, like a lawyer or accountant. But years ago when I spoke to many of my clients about this issue, they actually prefer to pay more and have the fees “hidden” (not in their face). It makes no sense, but there it is. I would much prefer if a client paid me directly. I’d end up earning more and the client would pay far less. Win-win. But human beings are what they are. It’s nuts, but there it is.

  • Tom Brown

    My Vanguard IRA brokerage though, does allow that. So you could roll-over 401k money to a Vanguard IRA (perhaps other company’s too?), open a brokerage there and then you have lots of options. The fee structure is dependent on how much you have with them. I’m no multi-millionaire (or even a single millionaire!) but the fees they charge are really low (like I describe above). I don’t know what they’d be for smaller amounts (like 10k or 50k). In fact, when I looked at it, it made no sense to use my 401k brokerage option, because however you figured it, it was more expensive, and you had to buy into it with a flat fee that amounted to ~$150 a year anyway (not terrible, but I could do a LOT of $2 trades at Vanguard for that much). Oh, now it’s coming back… I think the ETF trades are free if you trade Vanguard ETFs, but they charge $2 for third party ETFs. Anyway, since Vanguard does not offer any kind of Gold, Silver, or other commodities funds… and I was worried enough about the 1st debt ceiling fight in the Summer of 2011 that I was actually considering a back up plan (since then I’ve learned to ignore all this drama from congress)… I did the brokerage at Vanguard and committed a small amount of money to play with. It was kind of fun actually, and I traded more than GLD, SLV and PPLT (platinum)… in fact most of what I played in was high yield bond ETFs… and I made a couple of $1000 bucks or so over a few weeks… but the SLV burned me, and I had to scale back my time anyway playing around w/ that stuff, so I got out. It was basically a casino for me.

    So, you can use an IRA brokerage to expand your options for only a small cost… but you still can’t do real estate directly (although you CAN do REITs).

  • Tom Brown

    OK, thanks for the tip!

  • Tom Brown

    Again, another attraction (beyond day trading) is that the ETFs through a brokerage allow you to SELL IMMEDIATELY if you want that option… and when I was feeling jittery about the whole market/economy, that seemed attractive. I recall watching (in horror) the market drop HUGE amounts in 2008/2009 every day… knowing that even if I wanted to sell my mutual funds I’d have no idea when that would actually happen (except that it would take place over 24 hrs or so). I toughed it out and held tight then and didn’t panic and it worked out in the end.

  • Tom Brown

    What you write confirms everything I learned from John Bogel back in 1990! (in his book, “Bogle on Mutual Funds”). Your piece above could serve as the forward to a revised copy of that book!

    John has been more pessimistic about the market in general though in more recent interviews (you can see him on youtube). I think some of the shenanigans that happened over the past decade or so have shaken his confidence in some of the underlying assumptions of index investing (such as the “efficient markets hypothesis” (EMH)). I don’t think he’s recommending managed mutual funds though! … he’s just wondering about unusual correlations across asset classes, poor corporate governance and incentives, and poor investor quality (rather than single owners, like in the past, we’ve got these huge pension funds, etc., whose leadership is sometimes lacking or in bed with company management).

    I’m with him on all that! … (and in fact I’d add “I’m not getting back in until the clowns at the top lose their jobs and go to prison for fraud!” .. but that’s another story!)… especially when I learned that the EMH was a neo-classical invention, based on perfectly clairvoyant “agents” who have access to all possible information, and who act “rationally” at all times, even if these so called “rational” decisions might have to sort through quadrillions of permutations of possible investments… taking billions of years to calculate even with the best computers. Suffice it to say that my confidence in neo-classical theories is at an all time low! But I still think the index funds are a better deal than managed funds in general…