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Charles Mizrahi
Charles Mizrahi

The Last Word -- Long term thinking

December 06, 2006
The Last Word -- Long term thinking

November 29, 2006, is a day that mutual fund executives throughout the land should mark on their calendars as a legal holiday. For the first time ever, mutual fund assets eclipsed $10 trillion! [1] That's a lot of money even by government standards. Out of the $10 trillion in mutual funds, stock mutual funds have $5.7 trillion, up from a modest $250 billion in 1990. For all the money that's in the hands of professional portfolio managers, how well have they done? Unfortunately, a large percentage of stock mutual funds fail to outperform the S&P 500 Index.

How could that be? Millions of families are doing exactly what they have been told to do: give their money over to professionals who will do a better job for them. Professional portfolio managers have the education, for the most part are intelligent, and have the best resources behind them. With all that going for them, why are most mutual funds underperforming the benchmark? According to John Bogle, former CEO of the Vanguard mutual fund group, portfolio managers have gone from "stewardship to salesmanship." [2] Holding on to assets and keeping the AUM (assets under management) growing larger have become the name of the game. Since mutual funds charge a percentage of AUM, the higher the AUM, the more the management fee. The system that the mutual fund industry has created gives more incentive to managers to not lose money than to make it.

If a mutual fund is badly lagging the S&P 500 Index over a short period of time, the fund will most certainly experience asset outflows. If the fund continues to lag the index for longer periods of time, clients will pull even more money from the fund and the fund's AUM will drop. This would result in less management fee revenue. So before that travesty happens, senior management will many times "re-assign" or fire the portfolio manager and replace him or her with someone who can keep up with the index. This fantastic system currently in place in the industry rewards portfolio managers who can match the index and have less tracking error. Tracking error, the amount the fund deviates from an index, is not measured over three-to five-year periods, but mostly over four- to 13-week periods. In other words, the short-term random movements of Mr. Market are what mutual funds are trying to track – an impossible feat.

Having enormous amounts of money sloshing around the stock market with the focus on short-term random price movements, leaves us with a huge advantage. I recently had a meeting with a prospective client who asked at the end of my presentation, "What's your edge?" It was a good question, which most investors fail to ask. My answer was short and sweet, "I invest for the long term." That simple edge is something all investors can have, which will give them a higher chance of beating the stock market and allow them to sleep better at night too.

[1] Daisy Maxey, "Mutual Funds Pass $10 Trillion Mark," Wall Street Journal, November 30, 2006, p. C11.
[2] John Bogle, The Soul For The Battle of Capitalism. Yale University Press, 2005, pp. 167-8.

About the author:

Charles Mizrahi
Charlie Tian, Ph.D. - Founder of GuruFocus. You can now order his book Invest Like a Guru on Amazon.

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