Thursday, November 06, 2008

Can Investor America Get Its Moral Compass Back?

Recycled post from February of 2008 inspired after reading John Bogle:

How many minimum wage employees have been sacked because the till was short a couple of cents? How many tellers fired for adding a couple of cents to balance out? A teller caught adding or subtracting money to her drawer, no matter how small the amount, not only gets fired immediately but also runs the risk of dealing with the law. Yes, one cent is enough to get an $8/hour teller fired for violating the integrity of her position.

Yet, CEOs, earning 600 times what the average teller makes, a crime in and of itself, can get away with manipulating billions of - no, not cents - dollars. Do they get fired? Well, if they do, and that's a big IF, they are rewarded with millions of dollars, bonuses, and cushy deals where they will never have to work again.

Oh, that's right...they are allowed to get away with hijacking our economy because of the "risk" they take. Risk? That no matter how badly they do their job, they are guaranteed a lifetime, dining on goji berries, white truffles, gold leaf, and caviar.

The bottom line is, the chances of top executives or big time fund managers serving time or facing any consequences for violating the ethics of their profession is slim to none; that is, unless the greed and corruption ooze out from every pore as was the case with the Bernie Ebbers, Kenneth Lay, Jeffrey Skilling, Dennis Kozlowski etc.

If it's not the CEOs raking in the bucks at our expense, it's the fund managers who are notorious for skimming money from the working man, especially hedge fund managers. Everyone knows that the hedge fund industry, a hotbed of "legalized" corruption, is, at best, a playground of of the hyper-wealthy.

Mutual funds however, according to John C. Bogle, founder and prior CEO of The Vanguard Group, started out as an industry that looked more to stewardship. The main objective of the mutual fund, was to secure the shareholder’s assets. As financial America has transformed itself from an "ownership society to an agency society", mutual funds have become an "industry of salesmanship. It’s become a marketing business instead of a business of management", as Bogle puts it.

Agents or institutions are holding most of the stock in the nation and they are not representing the principles of the industry. The Investment Company Act of 1940 states mutual funds must be operated, organized and managed in the interests of the shareholders rather than in the interest of the investment managers and distributors. Today, corporate trustees and mutual fund managers are acting in their own interests and not in the interest of the underlying pension beneficiaries and the fund share-holders

There is a disconnect between those who own the fund and those who manage or who run the funds. They are working at cross-purposes. Managers make their money by charging the highest fees the market will bear. 1.6% does not sound like much but it makes a dramatic difference when compounded over time. Remember what Albert Einstein said about the strongest force in the universe, "compound interest".

Managers have an interest in getting mutual funds as large as they can to take home the largest management fees they can. The larger the fund, the harder it is to manage and the shareholder pays the price. As Warren Buffet says, “The fat wallet is the enemy of superior returns”.

The average cost of a mutual fund is 3% (1.6% - manager fees + 8/10 % for transaction costs + ½ % sales charge = 3%)

Let's say you get a 10% stock market in the future, subtracting the cost, the average fund will give you 7%. Doesn't sound like a big deal until you look at a compound interest table and look at what happens between 7% and 10% over 30 years. You will find at 10%, a dollar will grow to $18 in the stock market but if it earns only 7%, it will only grow to $9.

In addition, instead of long term value, managers engage in short-term speculation.
The average mutual fund turns over it’s portfolio, at the rate of 110% per year. That means the average fund holds its average portfolio stock for an average of 11 months. The brokers and managers make all the money when turnover is this high, not the investor.

Is that fair? When the investor puts up 100% of the money, takes 100% of the risk but only receives 25% the return?

It's up to the individual investor to capture as much of the market return as he possibly can and no one is going to do that for him. He can begin by finding out how much the fees are and moving his money to mutual funds that are tax and transaction cost efficient and find out which ones understand the wisdom of long term investment.

Financial Industry Regulatory Authority (FINRA) is the largest non-governmental regulator for all securities firms doing business in the US. It's very difficult to determine whether funds are fee excessive. FINRA.org provides a mutual fund analyzer that will calculate the fees associated with the shareholder's fund.

Our whole investment system, once focused on corporate value has gotten focused on corporate price. We’re a nation of investment traders, speculators rather than a nation of long-term investors. The only way to be successful is to capitalize on the wisdom of long-term investing and instead we’re all engaged in the measurable folly of short-term speculation. It’s the focus on the precise price of a stock, an illusion rather than the eternal reality which is the intrinsic value of the corporation…how much cash it will generate over the foreseeable future or lifetime. -- John C. Bogle

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