Section IV - Lesson 4
Managed Mutual Funds Versus Index Funds (Part I)
Mutual funds, as we know them today, were not created until the mid 1920’s when investment people and legal people put their heads together to develop a product composed of many securities that could be mutually owned by many investors. These early funds were called Investment Trusts, and most of them emanated from Massachusetts where the laws relating to “trusts” were favorable to their formation. Indeed, one of the largest and most popular of these early funds was called the Massachusetts Investors Trust.
The concept was simple and logical. A small investor, with only a few thousand dollars to invest, could now own his or her pro-rata share of a large, widely diversified, professionally managed portfolio of common stocks. Instead of owning shares of the actual stocks, he owned shares of the mutual fund that owned the stocks.
The small investor gained broad diversification, which he could never have accomplished by himself with a small amount of money, and he gained the relative safety that comes with such diversification. He gained the convenience of letting fund management take care of all the details of collecting and distributing dividends and interest, and keeping track of gains and losses. And on top of everything else, he gained the supposed benefits of professional management and selection of this portfolio.
In exchange for these benefits, the small investor gave up his rights to “call the shots.” As a shareholder of the fund, he turned the reins over to the manager, and would have no say in the selection of the stocks for the portfolio, or the sale of present stocks out of the portfolio. The success or failure of the fund was entirely in the hands of the manager.
It was thus very important for the potential investor to evaluate this fund before he purchased. Were the stated objectives of the fund in keeping with the investor’s own objectives? Did the past performance of the fund indicate that it was meeting its objectives? Was the present manager qualified to continue meeting these objectives?
Truly, the thing you are buying when you buy a managed fund is the management. You are placing a bet on the abilities of the person who’s managing the fund. This person may be well known, like Peter Lynch when he managed Fidelity’s Magellan Fund, or he may be not so well known, as is more usually the case.
The troubling thing about “buying management” is that managers seldom stay put. A sharp young person who is doing well managing one of a company’s smaller funds may be moved to one of its larger, more popular funds. This same manager may later be paid a bundle, by a competing company, to jump ship and manage yet another fund. The people who replace this manager for the first two funds may not be nearly as clever and astute as the original manager.
Another problem with “buying management” is that it’s not always easy to tell whether someone’s being extremely brilliant, or someone’s being downright lucky. The same manager who looks like a genius today can look like a dunce tomorrow. Success is fickle in the investment business.
The overall point to be made about managed funds is that management rarely stays static. Over the course of 30 to 50 years, which is the time frame of your investment program, a managed fund will have a number of different managers, some good, and some—well—not so good. You do not want to be selling your mutual fund every time you think the manager is bad. You don’t want to be switching from one mutual fund to another, in order to stay well managed. These are very real potential problems if you own managed funds.
Another point to be made about managed funds is that you usually pay dearly for the management of that fund. In the early days of mutual funds, before the advent of no-loads, it was not uncommon for a small investor to pay a 7½% or 8% load (commission) to buy a fund, and then be charged another 1% or more each year in management fees and expenses.
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