Review & Outlook

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An Ockham’s Razor for Investing, Part I

16 October, 2015 by Matthew O'Brien, Ph.D. in Commentary

Should a wealth manager spend his time picking stocks or picking funds that pick stocks?  I pose the question because at O’Brien Greene we pick stocks (and bonds and other publicly traded securities like real estate investment trusts or REITs) for our clients, and we think that this is a better way to spend our time — and deploy our clients money —  than in trying to pick other fund managers.

Perhaps the simplest argument for being a stock picker instead of a fund picker is the numbers game.  There are many more funds than there are publicly-listed companies in the U.S.  In 2014 there were 7,923 mutual funds in the U.S., according to the Investment Company Institute (ICI), which is the trade group for the industry.  Add to this 1,380 exchange-traded funds (ETFs), for a total of 9,303 funds to choose from.  By comparison, the Wilshire 5000 Total Market Index, which represents the entire investable public market of U.S. companies, includes just 3,809 stocks.  (For a variety of reasons, the number of public companies has been in decline; the last time the Wilshire 5000 actually had 5000 stocks was on December 29, 2005.)  Some simple screening cuts down the number of candidate stocks even more: when I screen for profitable companies with a positive enterprise value and a market capitalization greater than $300 million, the number of stocks drops to 2,208.  Furthermore, I can tell you from experience that the prospectuses of many funds are significantly more complicated than the 10-k filings of many companies.  (A 10-k is a description of a company’s business that it must file annually with the Securities & Exchange Commission.)

Not all mutual funds and ETFs are just stock funds, of course, but the general point stands: there are way too many funds out there and the bulk of an investor’s time is better spent studying securities and the businesses that generate their value, not fund prospectuses.  (I haven’t even mentioned all the grotesque annuity-wrapped products sold by the insurance industry that are masquerading as investments.)  After all, there’s no value in funds themselves; on the contrary, they only add complexity and costs.  Consider an example.  One fund that I often see in the 401(k) plans I review is the Growth Fund of America managed by American Funds.  It is sold by brokers in seventeen different share classes, by my count, each with different fee structures: some have up-front sales commissions, others have deferred sales commissions, most have variable marketing fees (i.e., 12b-1 fees) and all of them have different operating expense ratios.  Sometimes some of these fees can be waived; sometimes they can’t.  Quite often their operating expense ratios are temporarily lowered for fixed, contingently renewable periods of time, after which they automatically revert to higher levels — unless they don’t.

Why wade through these complexities and costs?  The Growth Fund of America owns large, growth companies like Amazon, Gilead Sciences, and Home Depot, which can easily be owned directly through a separately managed account.  Stock mutual funds are a reasonable investment vehicle for small investors who have, say, less than $100,000 to invest, because the fund structure allows for efficient management and diversification.  But the price for these benefits is real.  First, there’s the increased possibility of outright fraud: the Securities & Exchange Commission recently fined the asset manager First Eagle for bilking tens of millions of dollars from their mutual fund investors through inflated recordkeeping fees layered inside of their funds.  Second, there’s the greater tax liability: if you bought a mutual fund in a taxable account last year, then you probably had to shoulder some of the $132 billion in distributed capital gains passed on by mutual fund managers.   That is, you had to pay part of the taxes on other investor’s returns, even if you didn’t make any money.

In spite of these drawbacks, many larger investors who could own their securities directly instead of funds don’t.  Only about 14% of US households own stocks directly, according to the Wall Street Journal, while 43% of households owned mutual funds in 2014, according to the ICI.  Why?  There are several reasons why funds are more prominent than they should be, and they all stem from the self-interest of the retail financial services industry.  I’ll address these in a subsequent post.