9. Investing in Investment Funds

Mutual funds represent a relatively recent investment vehicle that is increasing in popularity. Hundreds of such funds exist, each claiming a general investment strategy depending on the methods by which they are managed.

In effect, a mutual fund is an investment corporation whose shares represent ownership in the securities they hold, and are essentially the same as a group of investors pooling their capital and hiring a staff to monitor and manage their investments.

Because they permit investment of a small amount of capital, as well as professional management, they are increasingly appealing to "average" investors with limited capital and expertise. There is a bewildering array of choices, and the general question of whether they are a worthwhile investment. The present chapter will consider them in detail.

Investment Fund Performance as a Whole

In a general sense, the author suggests that mutual funds have served a useful purpose: they have promoted the habit of savings and investment, protected unsophisticated individuals against costly mistakes in the market, provided broader options for small-scale investments, and by and large it is expected they have provided a return that is better than would have been obtained by the average person managing his own investments directly according to the same strategies.

The last point is true not because mutual funds have fared any better than the stocks they represent, but due to the erosion of value that results from the commissions for small purchases in a wide array of finds, and that a responsible mutual fund manager is generally less subject to the sort of panic and greed that can draw an individual from a sound course of investment.

In terms of their performance compared to the market, the returns vary. Some outperform one or both major market indices (Dow and S&P), others significantly underperforms them. Taking the average of the ten largest funds over a ten-year period, their performance has been slightly better than the S&P composite (105.8 vs 104.7) but far better than the Dpw (83.0), though they vary greatly in range (from 44.2 to 152.2)

As such, the author does not feel it would be fair to criticize mutual fund companies as a whole for doing little better than the market as a whole, but nor would it be particularly meaningful, as their investments as a whole are likely to be as diverse as the market. However, some funds have performed very poorly, and others quite well, as a result of the expertise and discipline of their management.

Which begs the question: can the investor predict which funds will have superior results?

The notion of considering the historical price of a fund as an indication of its future performance is as error-prone as making the same assumption about any individual stock. And while it would be possible to assess a fund on the basis of its present holdings, there is no basis for knowing what investment decisions its manager may make in future.

Largely, the investor must consider the investment strategy of a given fund and determine whether it is in agreement with sound investment policies.

Performance Funds

One disturbing development in recent years has been the emergence of the "cult of performance" in the investment management industry, which began in the competition of mutual funds and has bled over to some extent to trust fund management. The author feels it important to mention that this does not apply to the large majority of well-managed funds, but only to a relatively small number of funds that have attracted a disproportionate amount of attention.

The idea is straightforward: managers of performance funds set out to outperform the market indices, and the degree to which some funds succeeded in doing so for a while gained considerable publicity and interest. However, what is not as widely publicized is that such a goal cannot be undertaken without incurring sizable risks that, within a short time, came home to roost: many such funds have not been successful from the onset, and those that enjoyed short-lived success eventually result in a more lasting failure.

The prime example of this patter was the Manhattan Fund, which organized in 1965 and posted gains of 38.6% in 1967 (against an 11% performance of the S&P index during the same period) - but in the following year, the fund lost 7.3% wile the S*P gained 10.4%; then it lost 13.3% in 1969 and lost 36.9% in 1970; and returned to a profit of 9.6% in 1971 (well below the S&P return of 13.5% that same year).

The securities held by the Manhattan Fund were "unorthodox to say the least" Two of its largest investments were in companies that filed for bankruptcy, a third faced legal action by its creditors. The founder and manager of the fund invested less than $1 million in the fund he managed and kept over $20 million in the funds managed by of other companies.

This is not unusual: a book published in 1969 profiled nineteen investment managers who achieved stellar returns for the funds they managed based on their performance in the preceding two years. In the year the nook was published, all of their funds took losses, and in the following year, they did even worse.

From the author's perspective, this is a new face on an old practice - bright and energetic people, usually young men, have promised to work miracles with other peoples' money "since time immemorial" and have usually been able to do so for a short time, but eventually ruined the fortunes of those who trusted them. These "miracles" were often accompanied by means that were on the fringes of fraud, and even when not strictly illegal were clearly unsound.

The timing of their return coincides with a loosening of legal restrictions and less vigilance overall. The SEC reacted sternly to similar "shenanigans" in the 1920's that played some role in the market crash of 1929 - and which over the course of forty years had slowly been rescinded and not vigilantly enforced.

All this considered, the implicit conclusion is that there are implicit risks involved in seeking to achieve spectacular results should serve as a warning to investors who assume that such claims can be sustainable achieved.

Funds that have consistently outperformed the market indices over a ten0-year period do exist - but there are very few of them, and the degree to which they have succeeded have been marginal.

Closed-End and Open-End Funds

Some consideration is given to open-ended or closed-ended funds, the former of which enable their investors to purchase and redeem shares at any time, the latter of which require investors to lock into an investment for a fixed period of time.

Generally, closed-ended funds charge a lesser premium and lower commissions, by virtue of reduced trading activity in their shares. Ultimately, reduced operational costs do not guarantee better overall performance, but merely subtract less from whatever profit may be made.

The salesmen of open-ended funds are quick to point out that closed-ended funds are locked down, so the investor may not be able to access his funds in an emergency situation, nor can he be sure of the return he will get from them when he will be permitted to redeem his shares.

There is also the matter of "load", or charges levied to redeem or purchase shares in a fund, which generally covers the costs of setting up an account and offering a commission to salesmen. These also do not affect the performance of a fund's holdings, but reduce the net return to shareholders.

Balanced Funds

There are also "balanced" funds that mix some portion of their holdings in bonds rather than in stocks as a means to mitigate fluctuations in the market and offer investors a single "package" for their entire investment portfolio.

Upon some consideration, it appears to be more logical for the investor to manage his bond investments directly rather than as part of a mutual fund package - and then investing appropriately in stock-only mutual funds that seek to achieve a market return. There is little difficulty for investors to directly purchase US savings bonds or high-grade corporate bonds, and no benefit in paying a fee or commission to a fund manager to do so.