Monday, December 29, 2008

Mutual Funds Paint over the Rust

At the close of financial markets for 2008, mutual funds must take a snapshot of themselves and disclose it publicly. Here is a short list of the main information that they will disclose:

1. 2008 return (or loss in most cases).
2. Main investments held.
3. Comparison to a benchmark.

You might not think that there is much that mutual funds could do to paint a rosier picture, but as Jason Zweig explains in a Wall Street Journal article, mutual funds have a few ways to paint over the rust.

1. Painting the tape.

Mutual funds inflate returns by buying more shares of stocks they already own at the end of the last day of trading. The extra demand drives up the price that gets reported for the end of the year. The price usually drops back down on the first trading day of the new year so that the fund actually loses some money doing this, but it has the desired effect; the reported 2008 returns will be slightly higher.

2. Window Dressing

Who wants to find out that their mutual fund bought a bunch of bad investments? Some mutual funds sell their losing investments and buy others that performed better during 2008. This would be fine if the fund manager believes that the new investments will do better than the old ones in 2009, but that’s not the goal here. The manager wants to list investments that performed well during 2008 in the public disclosures.

3. Benchmark Hopping

The great thing about benchmarks is that there are so many to choose from. There are benchmarks of small companies, big companies, value stocks, growth stocks, bonds, and blends of all these things. The best way to make a mutual fund’s dismal return look a little better is to compare it to the worst-performing benchmark. Mutual funds are supposed to compare themselves to benchmarks that match their investing style, but as Zweig explains, a “study by finance scholar Berk Sensoy shows that 31% of U.S. stock funds pick a benchmark that doesn't closely reflect what they own.” I can’t break the world record for pole vault, but I could probably pole vault over the record high jump bar.

Not all mutual funds do these things, but many have in the past. It’s hard to understand why anyone would knowingly invest in funds that use these tactics.

3 comments:

  1. Maybe mutual funds should include a can of Tremclad with their annual report?

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  2. Gene: Good one. Maybe this would be a money saving move. Investors would paint over the rust themselves instead of having to pay someone else to do it.

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  3. Sadly, even with increased transparency you can never really trust someone who wants to take advantage of you. This isn't too surprising, and really makes me enjoy my index funds more!

    A good way to approach potential investments might be to think of them like Warren Buffet's initial partnerships - open one day a year and with no disclosure of the actual investments. If you wouldn't be comfortable with that, it's time to start learning for yourself. That's one way to check if you really trust someone, but it doesn't help if you trust the wrong person.

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