Image Credit: Christophe Vorlet
By Jason Zweig | June 5, 2010 12:01 a.m. ET
With the markets serving up nothing but lemons, it is high time Wall Street started helping investors make lemonade.
Stocks have gone nowhere for a decade, bond yields are near record lows and you couldn’t find the return on your money-market fund if you put it under an electron microscope. But the 10 major publicly traded fund-management companies had a combined $21 billion in revenue last year. Their net margins — the percentage of every dollar they take in that turns into pure profit — still are running at up to 25.5%, a rate most businesses could reach only in their dreams.
Middle-class American investors may desert the capital markets — as they did in the 1930s and again in the 1970s — based on their lousy returns alone. But the exodus could get even bigger if more financial firms don’t start giving investors a fairer shake. Here are a few suggestions.
• Cut fees. When returns shrivel, high fees hurt so badly that just about every investor feels the pinch. Roughly 175 out of 6,732 mutual funds have cut their fees so far in 2010, by an average of 0.07 percentage points, according to the researchers at Morningstar Inc. Not much, but it is a start.
• Slash tax bills. Much of the money-management industry still invests as if taxes were irrelevant to net returns. That is unacceptable. Every fund or investment strategy should be clearly designated as appropriate or not for taxable accounts and then managed accordingly. In the long run, taxes — generated mainly by realized capital gains — have reduced fund investors’ net returns by roughly two percentage points annually. Tax-wise management can close that gap.
If mutual-fund managers, financial planners and stockbrokers made a more-regular practice of investing alongside their clients, they would feel the same pain of paying unnecessary taxes — and quickly learn the importance of minimizing those liabilities. Perhaps the most important question investors should ask any financial professional is “How do you invest your own money?”
• Set limits. A new study sponsored by the International Centre for Pension Management in Toronto finds that, even among pension funds with access to the world’s best money managers, the smallest accounts earn the biggest returns.
Yet very few investment firms close funds (or stop taking new money) when they are in danger of growing too large to be effective. Closing would reduce the rate at which their management fees can rise. But when performance suffers and investors’ enthusiasm fades, fee income falls anyway. Firms should automatically close fast-growing funds in less-liquid markets like small stocks, hot industry sectors and emerging markets.
• Leave the herd. The market can’t function optimally when tens of thousands of professionals managing trillions of dollars act like sheep, locked into simultaneously pursuing whatever happens to be going up in price and fleeing whatever is falling.
By thinking like each other, they protect themselves. As a stock rises in price, it becomes a bigger part of the market index, forcing fund managers to buy more of that stock or be left behind in the performance derby. More buying imparts further upward momentum to the stock’s price, increasing its weight in the index and setting off another round of buying.
With such herding, “mispricing is inevitable,” says Paul Woolley, a former fund manager who now studies “capital-market dysfunctionality” at the London School of Economics. In fact, professional investors — who should be protecting their clients from market crashes — may be making booms and busts worse with their herding behavior.
To break the momentum cycle, Mr. Woolley would shun all investing strategies with annual portfolio turnover rates above 30%. He would jettison broad market averages like the Standard & Poor’s 500-stock index as the benchmarks of performance — instead measuring managers against the growth rate of the national economy, adjusted for risk.
• Measure up. The investment industry is built on a single premise: “Our actions improve your returns.” There is a simple way to see whether the premise is true. At year end, ask your broker or financial adviser to report not only how your portfolio actually did, but how it would have done if he had left it at a standstill, making no changes for the entire year. The idea is being floated by George Feiger, chief executive officer of San Francisco-based Contango Capital Advisors, which manages $1.7 billion.
The standstill comparison wouldn’t only show you whether your investment adviser did add value. It would also force him to ask whether each of his actions is likely to add value. That, in itself, might lower your risk and raise your return.
Source: The Wall Street Journal, https://www.wsj.com/articles/SB10001424052748704080104575286580479578498
Resources:
Definitions of ACTIVE, FEE, FINANCIAL ADVISOR and PORTFOLIO MANAGER in The Devil’s Financial Dictionary
The Velocity of Learning and the Future of Active Management