More 401(k) Problems?

Here's an article from IndexUniverse.com titled "Auditors Finding More 401(k) Problems".

The article talks about the IRS is finding a "substantial" increase in the number of compliance problems in 401(k) plans. Not surprisingly, the problem is especially troublesome for small businesses.

It's a short article, and worth a quick read. We especially agree with the sentiment in it's conclusion:

"So what does this all mean for index investors? It could be another sign that pressure is building to clamp down even more on the use of high-priced actively managed funds."

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Focus On Fees: The Sales Load

When it comes to mutual funds, a load is another name for a sales fee that investors may pay to a mutual fund company for buying or selling shares of a fund. Think of it as a commission that the fund company gives to brokers who sell the fund to investors.

A load mutual fund charges this fee to investors, a no-load fund does not.

Loads usually cost between 4% - 8% which comes directly out of investors’ assets. The Financial Industry Regulatory Authority (FINRA) has capped sales loads for mutual funds at 8.5%.

There are two main types of loads:

Front-end loads are paid when you purchase shares in the fund. If you invest $100,000 in a fund with a 6% front-end load, you will pay $6,000. That means only $94,000 of your money will actually get invested in shares of the mutual fund.

Back-end, or deferred loads, are paid when you sell or redeem shares of a fund. Back-end loads are usually based on either the amount of your initial investment or the value of the investment when you sell shares – whichever is lower. If you invest $100,000 in a fund with a 6% back-end load, the full $100,000 gets invested in the fund. When you sell, however, you will pay $6,000 as long as the value of your investment is still $100,000 or more. If the value of your investment has dropped to $90,000 when you sell, the sales charge will be $5400. This is not always the case, however. You could end up paying a deferred load on the full amount of your investment if it increases in value.

One last note on back-end loads. The amount of the load may be affected by how long you own the fund. For example, the load could be 6% if you sell within the first year then drop to 5% if you sell in the second year and go away completely after some timeframe. To find out how the deferred loads are calculated check a fund’s prospectus. (Or, better yet, just stick with no-load funds so you don’t have to worry about this.)

There is a third, less common type of load - the constant load fund. Constant load funds charge an annual sales fee to investors. The loads on these funds tend to be lower than those of front-end and back-end mutual funds. To offset these “lower” fees, however, these funds will usually have higher expense ratios than those with front or back end loads.

As is the case with expense ratios, it’s pretty easy for investors to find out what the load is for a mutual fund. You can find it in the fund’s prospectus or on your favorite finance site.

Let’s look at the page for the Vanguard Small Cap Index fund on Google Finance. On the right side of the page under “Key Statistics” there is a line item for “Front load” and “Deferred load.” In the case of this fund, there are no sales charges so it is considered a no-load fund.

Next, let’s look at the page for the Fidelity Advisor Small Cap Value A fund. Notice that next to “Front load” in the Key Statistics section this fund has a load of 5.75%.

Lastly, we’ll look at the page for the Fidelity Advisor Small Cap Value B fund. This is a back-end loaded fund, as seen by the 5% listed by “Deferred load” in the statistics.

(Quick side note: funds that are designated as having Class A shares usually have a front-end load, Class B shares usually indicates a fund with a back-end load. In the case of the Fidelity funds above, they are basically the same funds containing the same investments. The only difference is when they charge the load to investors.)

The most important lesson for investors when it comes to loads can be illustrated by looking at this chart. It compares the returns for the funds we looked at above. As you can see, the no-load Vanguard index fund greatly outperformed the two loaded Fidelity funds. In fact, over the past 5 years, if you had invested in the Vanguard fund, you’d have over 3 times as much money in your account than if you owned either of the Fidelity funds.

In all fairness, there are probably some loaded small cap value mutual funds that have outperformed the Vanguard index fund. However, while Wall Street and money managers would like you to believe otherwise, paying a sales load for a mutual fund does not guarantee a higher return. There is no evidence that load funds can outperform no-load funds.

Paying a load does guarantee two things:

1. Your broker will make more money than if you bought a no-load fund.

2. The fund will have to outperform the market – and then some – in order for you to just match the returns of an index fund.

When it comes to sales loads on mutual funds, it’s best to follow the advice most commonly given by everyone except those who sell loaded mutual funds: avoid them and stick to no-load funds.

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It’s Not Just the Size Of the Fees In Your 401(k) Plan, But the Funds It Uses

Add Wal-Mart to the list of companies being sued by employees for breach of fiduciary duties of their company 401(k) plan.

One of the interesting things about the Wal-Mart suit is that employees are not just suing over the alleged unreasonable fees charged by the plan. The suit also claims that participants’ returns were adversely affected because most of the funds offered in Wal-Mart’s 401(k) plan were actively managed funds. An article from Pensions and Investments describes why employees added this to their suit (emphasis ours):

The suit against Wal-Mart alleged the basic fees weren't the only factor that adversely affected workers' 401(k) savings. It stated that most 401(k) plan fund options are actively managed funds, which carry higher management fees. The Wal-Mart plan's actively managed funds, which cost more because they aim to garner better returns than market indexes, often did not meet or exceed their investment benchmarks, according to the suit. This underperformance compounded the effect of the fees, as participants paid more for lower returns, the suit said.

The suit breaks down the fees on many of the actively managed funds in the Wal-Mart 401(k) plan and measures them against funds from Vanguard Group, known for offering relatively low-cost mutual funds. In one example, the suit compares the AIM International Growth Fund — an actively managed retail fund in the Wal-Mart 401(k) plan that has an expense ratio of 1.59% of assets — with Vanguard's International Growth Fund, also an actively managed retail fund with a fee of 0.55% of assets. The difference for Wal-Mart plan participants: $2.8 million less in fees over a six-year period with the Vanguard offering.

We’ve been beating this drum for a long time now. It’s not just the fees that can eat into your 401(k) returns but active management risk (aka the fallacy that fund managers can consistently outperform the market). A 401(k) plan that only uses actively managed funds is doing a huge disservice to plan participants who will often do much better sticking with index funds.

It looks like more 401(k) plan participants (and lawyers) are starting to take notice.

You can see the full version of the P&I article here.

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Avoid This $100 Billion Scam

$100 billion dollars.

That’s what investors are collectively paying Wall Street every year in an attempt to beat the stock market. This according to the results of a new study, “The Cost of Active Investing,” by Dartmouth Professor Kenneth R. French.

So what do investors get in return? According to Professor French’s research, worse than nothing. In fact, the study finds that if investors had simply invested in a passive market portfolio (ie. index funds) between 1980 and 2006, they would have boosted their average annual return by 67 basis points.

And as we've written about before, Small Percentages Add Up To Big Money.

There’s an excellent article in the New York Times that examines this study in more detail. The bottom line?

“The best course for the average investor is to buy and hold an index fund for the long term. Even if you think you have compelling reasons to believe a particular trade could beat the market, the odds are still probably against you. “

You can read the New York Times article here.

You can download Professor French's study here.

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The Huge Gap Between Fund Returns and Shareholder Returns

They’re hard to ignore.

Those eye-popping returns featured in the ads for the mutual fund industry are very attractive. Why try to match the market when it looks like you can smash the market by investing in the right mutual fund?

Unfortunately, things are not always as they appear.

At a talk to the Financial Industry Regulatory Authority, John Bogle, the founder of Vanguard, shared some startling data.

Returns for the S&P500 from 1980 – 2005: 12.3%

Returns of the average fund from 1980 – 2005: 10%

And how well did investors do in that time period? No one knows for sure, but it appears they did much worse than 10%.

As an example of how bad investors might have fared in that time period, Bogle looked at the returns of the 200 funds with the largest cash inflows from 1996 – 2005. Those funds reported average returns of 8.9% for the period. The dollar-weighted returns (the returns shareholders actually earned) were an abysmal 2.4% - just 25% of what the funds themselves returned.

Of course the fund industry will say that it’s the investors fault for not staying fully invested during that time. Bogle has a different view however. He sites 3 main reasons that the mutual fund industry plays a big role in the dismal returns actually earned by investors.

1. “It was we in the fund industry who created those new funds that were to create such havoc for investors. As the market soared ever higher, we introduced those 494 brand new “New Economy” funds. Only a precious few of the major fund marketers had the courage to stand firm against the market madness, and forbear from creating and offering such funds.

2. When we had funds whose performance turned “hot,” we marketed them aggressively. Our public relations departments were willing co-conspirators with the press in establishing interviews with our “star” portfolio managers, many of whom, inevitably, turned out to be comets.

3. The higher a fund’s performance soared, the more we advertised our returns. Example: In March 2000, the month the market hit its high, there were 44 equity funds that advertised their performance in MONEY magazine. The average advertised annual return was +86 percent. Imagine! (During the next three years, these funds were to plummet by 39 percent.) Unsurprisingly, after the fall, in the October 2002 issue ofMONEY there were only four funds that did so.”

We have two lessons here:

1. Invest for the long term. Market timing does not work.
2. The “eye-popping” returns featured in the ads for actively managed funds are very misleading. The overwhelming evidence out there indicates that investors would be much better off investing in low cost, passively managed index funds.

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"The Big Investment Lie" Message Spreading Across the World

One of our favorite books is "The Big Investment Lie: What Your Financial Advisor Doesn't Want You to Know" by Michael Edesess.

Since his book was published, we have gotten to know Michael Edesess and were thrilled to have him stop in St. Louis yesterday to visit with us. We need more financial industry insiders like Michael out there exposing the deceptive tactics the industry uses to take investors' money.

What's the net effect of these deceptive tactics?

Mr. Edesess claims "What has not been widely accepted yet as an established statistical fact is that professional investment services companies do not increase the growth of their clients' wealth but decrease it."

This is an important message that is starting to spread across the world. Here is a review of the book in the Shanghai Daily, China's largest English daily . . .


A financial advisor confesses: It's all a bunch of lies and hype
Created: 2007-12-1
Author:Wan Lixin


MICHAEL Edesess' book is a warning to all investors, and it is particularly timely for small Chinese investors.

With our historic bull market turning into a rollercoasting dip, some have just awakened to the fact that the unprecedented bull run affords no more than another occasion for wealth redistribution.

In "The Big Investment Lie: What Your Financial Advisor Doesn't Want You to Know," Edesess takes an insider's look at the tricks investment managers employ in separating investors from their money. Edesess, who was once a founding partner and chief economist of a financial group, knows what he speaks of.

In a recent television interview, former Morgan Stanley star economist Andy Xie was asked to comment on his success as a wealth manager after being forced to resign due to the leak of a sensitive e-mail from him

"You know, idiots are making money these days," Xie said, beaming inscrutably, clearly unwilling to make much of his accomplishments.

Edesess would have corrected Xie by pointing out that only money managers make money, at the expense of their clients.

Coming as it were from a founder of a financial business, the book is not unlike a confession. The author admits that on numerous occasions he had witnessed how sales people lied to and deceived investors.

Chinese fund managers are fond of talking of common sense and discipline as a sure way to riches.

The legend is told of an elderly woman working at a parking lot for bicycles in front of a brokerage.

Wherever she found there were too few bikes for her to attend to, she began to buy stocks. And whenever she found the parking lot crowded, she dumped her holdings and returned to her old business.

Her homespun wisdom served her so well that after a few years - well, you know how the story ends.

Similarly Edesess' book tells of the US "Beardstown Ladies," a group of senior citizens who formed an investment club in the 1980s, and achieved fabulous success by exercising old-fashioned, American-heartland frugality and investing according to their commonsensical principles.

They were catapulted into national fame after alleging that they had achieved an average annual return of 23.4 percent over the course of the preceding 10 years, about 8.5 percent more than the return on Standard & Poor's 500 Index.

They were wrong.

"Compared with the Beardstown Ladies, whose fraudulent practice was unintended, the fraud of the investment advice industry is studied, refined, Wall Street minted and Madison Avenue packaged," Edesess observes.

The money managers have to lie because this is the only way to persuade their clients to part with their money.

As the author says, while it is not unusual for any money manager to beat the market over a period of time, it is rare for any money manager, professional or amateur, to beat the market consistently.

Thus, the managers' frequently used trick is to attract their clients by lying - trumpeting and exaggerating any winning performance.

This is very similar to the strategy adopted by the lottery agencies in China.

On Thursday, Shanghai Morning Post devoted a whole page to an unknown lucky buyer in Gansu Province who had won 113 million yuan (US$15 million). The lottery authority regularly publicizes winners.

Interestingly, on the same day the Oriental Morning Post gave prominent coverage to an unlucky buyer in Shanghai who had cheated relatives and friends 16 million yuan to buy lottery tickets.

How many frauds and thefts have been triggered by reports of a stroke of good luck?

Money managers are familiar with this selective disclosure of information, because their only aim is to enrich themselves.

"What has not been widely accepted yet as an established statistical fact is that professional investment services companies do not increase the growth of their clients' wealth but decrease it," Edesess claims.

Disciples of scientism

The brokers enrich themselves by charging high brokerage fees, and they have shown great originality in devising other means of robbing investors, for instance through the so-called "loads" and the "wrap fees."

But the author claims none of the charges compares to the hedge fund charges, which can be more than double the returns to an investor.

"Hedge fund management is not just a license to steal; it is a license to steal literally billions," the book says.

So the real challenge for money managers is, rather than pondering on the impossibility of constructing a portfolio that beats the market, to devise the means to lure clients in.

"The investment services business is first and foremost a sales business. It focuses the largest part of its effort on determining what sales pitch the customer will buy," Edesess observes.

Philosopher Friedrich von Hayek called the misguided application of natural science "scientism," and market prognosticators and analysts are all disciples of scientism.

The seemingly scientific techniques and presentations are a sheen, clearly useless in dealing with the market that moves randomly, where past performance will never be a reliable gauge of future performance.

But market analysts seem to have a handy answer for everything.

For instance, when property shares experienced sudden falls this Wednesday, all the analysts knew why.

One identified the new policy on affordable housing as the culprit. The second blamed the rumored collection of property taxes. The third said it was but a technical correction in the run-up to a big rally.

PetroChina share prices have shed over 2000 billion yuan in its market value in a week of steady decline, trapping over one million of small investors.

In one sense the market analysts are also victims, as they have to drastically and steadily lower their former valuation of the share.

As the author claims, investment firms prosper by downplaying the known facts. Their sales representatives often interpret their research findings in a way that suit their purposes. They look respectable, earnest, well-informed, and like to speak in an impenetrable language spiced with technical jargon.

But investors often conspire in their own downfall, as their greed blinds them to the inherent risks of entrusting their money to others.

They should be reminded that whenever they put money in a fund, they do so at "agency risk," which stems from the inherent conflict of interests between the principal and the agent.

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Copyright © 2001-2007 Shanghai Daily Publishing House

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