“A cynic knows the price of everything and the value of nothing.” Lady Windemere’s Fan, Oscar Wilde
Photo: Napoleon Sarony, 1882. Source: Metropolitan Museum of Art
Full disclosure: I am a financial professional who manages money. So my comments are slanted. After all, where you stand often depends on where you sit. And I sit where I can manage individual and institutional portfolios, using—mostly—individual stocks and bonds. I avoid using mutual funds because of the conflicts that are inherent in their business model.
What conflicts? Mutual funds provide an efficient way for an investor to own a stake in a portfolio of securities. They can own a broad index like the S&P 500 or the Barclays Aggregate Bond Index, or they can have a fund manager actively choose which securities to own. They’re typically managed by a fund company, which charges an annual fee based on the assets in the fund. Index funds are typically cheaper, since they’re not paying a manager to pick stocks or bonds. There’s a lot of emphasis these days on using cheap index funds to manage your money.
But not all indices are created equal. Some indices are “open,” meaning that everyone knows what will go in and what comes out on specified rebalancing days, while others are “closed.” Some indices charge more for their analytical information than others—what weights they use for different securities, what categories they classify them into, and so on. So mutual funds have an incentive to use cheaper indices as their benchmarks—even if their open structure leaves them vulnerable to arbitrage.
Here’s the way it works: An open fund has a simple rule to determine who is in and who is out of the fund, and a date set when they will rebalances. Arbitrageurs buy or sell securities before that date, knowing that anyone who strictly follows the index will only buy or sell when the index does. By doing this, the arbs can scalp as much as 2-4% from the index’s performance.
Consistent underperformance of an “open” index. Source: Bloomberg
But the index fund’s investors have no idea that this is going on. They just see that their fund has performance that tracks the index. And they see a low management fee. So the mutual fund wins—they get to market themselves as “low cost”—and the arbs win, by scalping performance. But the mutual fund’s investors lose—without ever knowing it. And there’s no requirement to disclose a fund’s performance against a different index.
Remember those mileage stickers that car companies put on the windows of new cars? They always come with a caveat: your mileage may vary. Cost may be a place to start when evaluating an investment, but it’s never where you should stop. Fees matter. But they only indicate a fund’s price. Not its value.
Douglas R. Tengdin, CFA
Chief Investment Officer