Wall Street WARZONE

Mutual Fund Portfolio Managers: He Made $436,500? And You Lost How Much? Not Fair!

by Paul B Farrell, JD, PhD
| | 2/15/2010

Nice work if you can get it! Americans invest over $10 trillion in mutual funds. There are about 70,000 portfolio managers. Average compensation was around $436,500 annually a few years ago. With 10 years experience, the average jumped approximately $1.8 million annually. Unfortunately, in spite of their fabulous compensation, they still hate indexing even though each year 75-85% of them cannot beat their indexes, and only one manager has been able to beat the S&P 500 every year for the past fifteen years. His streak ended in the credit meltdown. Thanks to a network of highly effective lobbyists, a protective Congress and a pro-management SEC, managers continue “stealing” one third of Main Street investors’ returns in broad daylight, with no serious legislative and regulatory oversight.

The Economist magazine offers a textbook description: “Imagine a business in which other people hand you their money to look after and pay you handsomely for doing so. Even better, your fees go up every year, even if you are hopeless at the job. It sounds perfect. That business exists. It is called fund management. … The average profit margin of the fund managers that took part in a survey by Boston Consulting Group was a staggering 42%. In part, this is because most fund managers do not compete on price.”

So let’s test this descriptionbeginning with a simple question to see how smart you are about mutual fund expenses. The facts are simple: A few years ago, investors paid Fidelity Magellan a $429 million annual fee to manage their $55 billion fund. In contrast, investors pay Vanguard only $99 million to run the Vanguard 500 Index Fund, which at the time alsomanaged $55 billion in assets. Two funds, same size.

So the question is very, very simple: What is Fidelity doing with the extra $330 million they take from investors? Or, more accurately: What did Fidelity’s investors get that Vanguard investors didn’t? After all, $330 million is one helluva lot of extra compensation—so you’d expect Fidelity’s investors gotten a much better return, right? Wrong! They actually got less… but I’m getting ahead of myself.

Why are Fidelity Magellan’s expenses $330 million higher?

When I put the question to Fidelity’s staff, they were quick to tell me that Magellan’s 0.78 expense ratio is half the average 1.46 percent ratio for all stock funds. But, that begs the question. Here’s the real comparison: Magellan 0.78 expense ratio was more than four times Vanguard’s, which was a mere 0.18. So that is how Fidelity got $330 million more than Vanguard.

But, you ask, isn’t Magellan an actively-managed fund that requires a bigger staff of pros, and the Vanguard 500 Index Fund just a simple index fund that doesn’t need much in the way of management expertise? True, a high school kid could manage on a cheap laptop over Pepsi and pizza during recess. How do I know? Because years ago in an interview with Gus Sauter, the guy who manages $200 billion of Vanguard’s index funds, Gus told me that when he started with the S&P 500 index an old “286″ computer was enough power to handle the index. Remember, there are only 500 stocks in the S&P 500 and they don’t change much. You could put all that data on one floppy disk!

Magellan’s manager made risky bets on high-flying stocks

Fidelity’s public relations staff said the reason Magellan was charging a hefty $330 million bigger annual operating fee than Vanguard charges for its S&P 500 index fund is quite simple: Fidelity provides active-management expertise that enhances performance to beat the S&P 500. But does the strategy work?

Here’s how Magellan’s manager Robert Stansky described his strategy in a Money interview with Jason Zweig: “How do you beat the S&P 500?” Stansky asked rhetorically: “You beat it by over-weighting some groups, under-weighting others, and by owning stocks that aren’t in the S&P. Sometimes I think if people knew how risky I was acting in the portfolio they’d really be surprised. Just go back a bit: I made AOL very big; I made Yahoo very big. I’m not afraid to make any bet.” Yes, he was bragging about big bets on AOL and Yahoo! In short, Stansky’s goal was very simple: Out-perform the S&P 500. And by implication, beat Vanguard’s S&P 500 index fund.

Is Fidelity Magellan just an “index fund in disquise?”

However, if you compare the portfolios of the two funds you’ll see they’re actually very similar. Which reminds me of a remark Ted Aronson of AJO Partners, portfolio managers handling $20 billion in pension money, made to me: Aronson said that all actively-managed funds are just “index funds in disguise.” And that’s exactly what I discovered: Magellan was indeed an index fund in disguise, yet justifying its excessively high fees on the basis that it was an better-performing actively-managed fund, which it clearly was not.

Here’s another example of Stansky’s management. I compared the two portfolios. Both have seven the same top-10 holdings and in very similar percentages: Microsoft, GE, ExxonMobil, Wal-Mart, Pfizer, American Int’l and Citigroup. Should investors pay $330 million for those kind of simple stock-picking decisions that a high school nerd could make during recess?

And what about the other three stocks? Magellan substitutes Viacom B, Wells Fargo and B/A in their top-10, for Coke, J&J and IBM, which had to be in Vanguard to match the S&P 500 index allocations. So at best, you could say Magellan is an “enhanced index fund,” not an actively-managed fund. But let’s get honest: Magellan is really just another boring no-brainer S&P 500 index fund requiring very little management. And Stansky’s so-called “big bets” hardly deserve $330,000,000 in extra fees annually.

Magellan investors paid $330 million extra … got nothing?

Now, to add insult to injury, we also see that Magellan is beating neither the S&P 500 index nor Vanguard’s index fund! Quite the opposite, Vanguard 500 Index was beating Fidelity Magellan on a one, three and ten year average basis. And that’s pretax so after-taxes it would be even lower because index funds are more tax-efficient. In other words, Fidelity’s naïve investors are forking out a $330 million expecting their manager Stansky to deliver on his promise of above-average, index-beating returns, but failed to materialize. Worse yet, this charade had been going on for more than a decade.

And to make matters even worse, while Vanguard is a no-load, at the time Magellan was forcing investors to pay a hefty 3 percent front-end load for the privilege of investing in this rather pseudo-index fund. Moreover, since that extra 3 percent was not included in their expense ratio, Fidelity’s investors are losing even more money than the $330 million.

When I ran this by Kevin Johnson, Ted Aronson’s partner in AJO Partners and one of Gus Sauter’s predecessors at Vanguard, Johnson had this to say about Magellan as an index fund in disguise: “For an organization that prides itself in its active management style and research capabilities, that’s surprising. Sounds like somebody’s collecting an awful lot of money,” but for what?

Are mutual funds “stealing” from investors?

So ask yourself: Where does all that money go? Answer: Into the pockets of the managers and owner. For example, while Magellan shareholders lost over 40 percent during the three-year bear market of 2000-2002, industry insiders told me that even though the SEC does not require public disclosure of management salaries, Stansky’s compensation was estimated to be well in excess of five million a year. Moreover, the Forbes 400 list of America’s richest billionaires reported that the net worth of Fidelity’s two owners, Edward Johnson and Abigail Johnson, increased from $11.1 billion to $12.3 billion between 1999 and 2002, making them the 19th and 38th richest people in America.

Vanguard, on the other hand, is not owned by a few elite and very rich owners, it is mutually owned by its 14 million individual shareholders, average Main Street investors . And as Vanguard’s communication officer explained: “Vanguard operates on cost basis, so it returns all of the profits, after expenses, to shareholders.” So there’s no extra profit siphoned off to paid to owners. I was also told that this is “the primary reason why Vanguard’s expense ratio is so low,” they distribute the profits to shareholders.

Investors should be “mad as hell” at this larceny

When investors recently read that Congress and the GAO were investigating fund expenses, a cheer when up. Something is seriously wrong in the fund industry today, when Fidelity’s 18 million shareholders lose roughly 40 percent while their owners gain ten percent and increase their net worth by $1.2 billion. Actually, it’s even worse: The average compensation of America’s portfolio managers’ increased 35 percent between 1999 and 2001. At the same time, fund directors voted themselves a 26 percent pay raise between 2000 and 2002 and were making an average of $249,500, for part-time work, the equivalent of a month a year. Something is definitely rotten in an industry that tolerates this kind of larceny running rampant and unchecked.

“Larceny?” I was going to soften things, and use the term “largess.” But this situation makes me angry. America’s funds have crossed the line from mere largess to grand larceny. Investors should be “mad as hell!” We lost huge sums during the 2000-2002 bear market, while this conspiracy of fund owners, managers and directors were looting investors returns. We should be mad! So now you got another reason to index!

FirstPubDate Feb’03

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