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By Jane Bryant Quinn
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David Swensen is mad at mutual funds, and I don't mean just a little sore. They're greedy, he says. They abuse investors. They milk you for fees. Their ads manipulate past performance to get you to buy. You're not only getting rolled, you're getting lousy investment results. When you're up against most mutual funds, you "lose in a first-round knockout." Whew.
Who is David Swensen and why should you pay attention to him? He's one of the most successful money managers in America today. In 20 years of running Yale University's endowment, he has outdone his peers, by far. His returns have averaged 16.1 percent a year, compared with 13.2 percent for Standard & Poor's index of 500 stocks. Together, his mix of investments--from stocks and bonds to real estate--have given him better returns with less market risk.
After the mashing the public took in the 2000-2002 market collapse, Swensen decided to publish a simpler version of his strategy that individuals could use themselves. So he started examining the investments people commonly use--and that's when his anger rose. He found poor quality and high fees, especially among mutual funds. His new book, "Unconventional Success: A Fundamental Approach to Personal Investment," lays out his case against most funds and offers a smart alternative.
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Swensen's outrage focuses primarily on costs. Mutual funds run by managers tend to charge high fees. Funds sold by stockbrokers charge even more. Managers buy and sell stocks at a rapid pace, which runs up the fund's brokerage expenses. The median cost to investors in 2002 came to 2.35 percent--and that doesn't count the upfront commission a broker might charge.
High costs chew up your investment returns. In studies of mutual-fund performance, funds with higher costs consistently do worse than low-cost ones.
What's Swensen's answer? Forget about mutual funds run by money managers and buy low-cost "index funds" instead.
An index mutual fund mimics the performance of a particular market. For example, take a fund that mimics Standard & Poor's 500 Index, which tracks the stock prices of 500 leading companies. The fund will own those same 500 stocks. As a result, it will always perform as well as the S&P index, minus costs. Other index funds track small stocks, international stocks and bonds.
Many investors hate the idea of tracking the market. They want to do better than the market, so they hunt for the hottest mutual funds. But in the investment world, "market average" doesn't mean "middling performance." It means "outstanding performance, thank you very much." The S&P average is like par in golf--the score that only the very best players get. Not many golfers consistently beat par, and not many managers beat the average.
As proof, take a study by Robert Arnott, editor of the Financial Analysts Journal. He looked at all the major stock-owning mutual funds (worth $100 million and up) in existence for the 10 years ending in 1998, and compared them with Vanguard's low-cost S&P 500 Index Fund. Over that period, the Vanguard fund beat the managers by 3.5 percent a year, pretax. That's huge.
A few managed funds beat Vanguard, of course, but there's no way of knowing in advance which ones they're going to be. You do know that a broad index fund, such as an S&P fund, will succeed. In fact, Arnott's study put its chance of winning, over the decade, at better than 6 to 1. Give me a horse with those odds and I'll bet on it.
As if the high cost of most mutual funds weren't bad enough, investors often sandbag themselves. You do it by chasing top performers, imagining that they'll do as well in the future as they did in the past. As you may have learned already, that's a bad idea.
The research company Morningstar rates funds based largely on past performance. Those with the best results get five stars; the next best, four stars, and so on. Money pours out of the laggards and into the top funds in the hottest categories--tech funds, growth funds, whatever.
And what happens? Almost always, the least-popular funds turn out to be the winners over the following three years, says John Reckenthaler, Morningstar's vice president of research. The investors who pile into the popular funds lose out.
Swensen has a single recommendation: Opt out of the mutual-fund merry-go-round. He sits on the board of TIAA, whose TIAA-CREF mutual funds he admires for "low costs and investor orientation." But he recommends Vanguard for its even lower costs and selection of index funds.
For long-term investors managing money in tax-deferred retirement accounts, he suggests something like this: 30 percent in U.S. stocks (a Total Market index fund, for both large and small stocks); 20 percent in international stocks (a Total International index fund); 20 percent in real-estate stocks; 15 percent in U.S. Treasury bonds (for protection against financial crises), and 15 percent in Treasury Inflation Protected Securities--Treasury bonds whose interest rate rises and falls with the inflation rate. You'll find similar funds at Fidelity Investments and T. Rowe Price.
This not only investing made easy, it's investing made smart.
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