The Bottom Line / The Mendacity of the Mutual Funds Industry

New research shows the more they charge, the worse the results

Eytan Avriel
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Are mutual funds coming back into fashion? After the 10% rebound by Israeli equities in January, in utter contrast to the ceaseless inundation of frightening news on the economic front, the public is starting to sidle back to mutual funds.

Initial figures for February indicate that the public withdrew several hundreds of millions of shekels from the safe harbor of money-market funds and put more than NIS 1.5 billion into mutual funds specializing in both stocks and bonds.

To be sure, the public's steps remain slow and tentative, but you can't argue with the numbers, or the conclusion: The appetite for risk is returning.

Before you phone the bank and start comparing mutual funds, you should note a study recently published in the Journal of Finance by two researchers hailing from Universidad Carlos III de Madrid: Javier Gil-Bazo and Pablo Ruiz-Verdu: "The Relation between Price and Performance in the Mutual Fund Industry."

Gil-Bazo and Ruiz took data on actively managed equity mutual funds in the United States from 1961 to 2005. They aimed to find out whether there was any correlation between a fund's performance (how much it makes for investors) and the level of its management fees.

Hundreds of studies had already concluded that actively managed mutual funds don't usually beat the indexes, so why investors continued to invest in them rather than in cheaper vehicles such as exchange-traded funds and index funds remained unclear.

But Gil-Bazo and Ruiz uncovered another conundrum. They found that on average, the worse the fund's returns (before deduction of fees), the higher the fees it charged.

Sound weird? It is. Logic would dictate that funds that do best could afford to charge the most, not the reverse.

Did the two researchers simply make a mistake? Their finding certainly flew in the face of economic logic. So they retested their findings, more stringently, and came up with the same clear result.

They sat down and thought about it, and came up with some theories to explain the anomaly.

Here's one: Mutual funds that know that their past performance is terrible raise management fees based on the realization that their clients evidently aren't sensitive to these fees.

In other words, bad mutual funds (by the test of performance over the past seven years) know perfectly well they can't compete over investors who have a clue. Their clientele are investors who haven't a clue, and therefore, they can afford to jack up their fees.

Then there's the marketing theory. Funds with a bad past performance have to invest more in marketing and sales, and have to pass these higher costs onto their clients.

To be frank, bad funds have no choice but to sell themselves to suckers - people who understand nothing and don't ask inconvenient questions.

Gil-Bazo and Ruiz studied the American market. What is the situation here? Well, a glance at local equity funds, mainly the ones that charge high fees, doesn't give me the warm fuzzies.

Looking at their returns over two and five years shows that most equity funds aren't beating the indexes. That goes for the funds that charge the most, too. So on what basis do their managers of 50 out of 161 equity funds allow themselves to charge fees of 3% of assets a year?

Maybe they think that the public is willing to pay higher fees to invest in equity funds because they figure the managers are working harder. But that's silly. Managing a fund that specializes in corporate bonds is just as labor-intensive, requiring just as much research and analysis.

Maybe the managers of the equity funds think that since the stock market is so volatile, nobody will even notice fees amounting to 3% a year.

Or maybe Israeli clients are just like American ones and don't check the facts.

Maybe they make decisions on what the next-door neighbor, cousin Yossi or the taxi driver says, or maybe they believe that fine-looking actor in the television ad. And you, ladies and gentlemen? On what basis did you choose your mutual fund?