I am shocked by the unfolding mutual fund scandal.I'm shocked that people, especially the regulatorsand politicians, are finding these revelations shocking.This is a small scandal compared to the realscandalâ€”the scandal that has cost investors billions ofdollars over the years and will continue to do so in thefuture. The much bigger scandal is that this is an industrythat was supposed to (and could) do the public anenormous amount of good. Instead, it's been a nightmarefor its customers.
Mutual funds were supposed to offer investors threegreat benefits: easy diversification, professional management,and low investment costs. They have disappointedon all three counts, primarily because most of the mutualfund industry has never been interested in its customers'well-being. Making money for itself has alwaysbeen its primary goal. The industry has also shown littleinterest in truly educating its customers. From its point ofview, an uneducated consumer is its best customer.
Bad to worse:
Mutual funds could easily provide investors withdiversification. However, almost all funds the industryoffers invest in one, often narrowly focused, segmentof the market. It's up to investors to create and managea well-diversified portfolio by combining variousfunds, often at a high cost. The industryhas heavily promoted highly risky, narrowlyfocused funds on the basis of their recent spectacularperformance. Fund companies do this, knowing thatthose funds are almost certain to reverse in the future.
Professional management has been the second areaof great disappointment. The majority of professionalmutual fund managers are not able to consistently dobetter than the unmanaged index funds. In many cases,they have not only done significantly worse, but theyhave also exposed investors to high risks. It's difficultto understand what they are doing to deserve theirenormous salaries. There are probably only a fewdozen fund managers who have been able to offer thebenefit of professional management.
Finally, instead of lower investment costs, most fundscharge the most they can get away with. These totallyunjustifiable costs add up to many times what investorsmay have lost from the use of their funds for market timingand late trading. To add insult to injury, most of thefund industry specifically collects marketing costs fromits customers, which it then uses to attract new customersfor its own benefit and run advertisements thatare designed to misinform and mislead everyone.
There is almost no chance that the real scandalwill be addressed and the industry will change in thenear future. Yet, going back to individual stocks is nota good approach for most investors. Therefore, youhave to look out for yourself and learn to use mutualfunds to your advantage, paying attention to theirstandard, unfulfilled promises.
Invest only in well-diversified funds, instead ofnarrowly focused funds. Don't get lured in by therecent spectacular performance of a narrowly focusedfund. Unless you're very knowledgeable in the markets,stick to index funds. Your chances of finding thefew truly talented money managers are miniscule.Invest only in funds that have no loads and avoid allfunds with A, B, C, or similar categories of shares.Finally, invest only in funds with expense ratios below0.5% and annual turnovers of less than 20%.
Chandan Sengupta, author of The Only ProvenRoad to Investment Success (John Wiley; 2001),currently teaches finance at the FordhamUniversity Graduate School of Business and consultswith individuals on financial planning andinvestment management. He welcomes questionsor comments at email@example.com.