Wall Street WARZONE

“7 Deadly Sins” of Mutual Funds: What They Don’t Want You to Know About How Their “Croupiers” Skim Off a Third of Your Money at Their “Casinos!”

by Paul B Farrell, JD, PhD
| | 4/25/2010

Occasionally the voice of an investor advocate shines through all the distracting hype and propaganda, if only briefly. “The small investor has never had a better friend than former SEC chairman Arthur Levitt,” wrote Warren Buffett in his endorsement of Levitt’s book, Take On The Street: What Wall Street and Corporate America Don’t Want You to Know. Yet, even with someone of Levitt’s stature, the Wall Street Hype Machine’s relentless drumbeat is so deafening and overwhelming that his message gets quickly drowned out.

What Wall Street really wants are investors acting like the rest of Americans—obsessed consumers with an insatiable need for instant gratification. By constantly stimulating their lower brain functions with Wall Street’s messages subtly inserted in endless misleading ads, educational materials, financial reports and emotional hooks that encourage impulsive actions, spending and living “in the now,” creating investors who are addicted to short-term thinking, and easy to manipulate.

Arthur Levitt opens on a personal note: When he took over as the chairman he sold all of his stocks and bonds to avoid any appearance of a conflict of interest. His $10 million-plus portfolio was reinvested in mutual funds, which he’d never previously owned. One thing he saw all over the fund industry was a lot of portfolio managers who were publicly encouraging investors to focus on the long-term—while doing just the opposite, thinking short-term, turning over their entire portfolios every year.

When he started reading fund prospectuses he was shocked. He was a former chairman of the American Stock Exchange with sixteen years experience on Wall Street. And yet “what really got under my skin was that the documents were impossible to understand,” he wrote in his classic, Beat The Street: What Wall Street and Corporate America Don’t Want You to Know. “At first I was embarrassed. Then it hit me: If someone with 25 years in the securities business couldn’t decipher the jargon, imagine the frustration of the average investor.” And that was just the tip of the iceberg among so many “troubling practices” Levitt discovered in the fund industry.

Cutthroat used-car salesmen thriving on hype

Levitt saw the mutual fund industry’s split personality: “Eager to be seen as pro-investor, but the truth is they aren’t.” In fact, Levitt had a hard time containing his disdain for the fund industry, referring to it as “a culture that thrives on hype … withholds important information” and a “cutthroat business” that regularly “misleads investors.” A truly stinging indictment.

His biggest gripe is that “most of the players in this highly profitable industry are reluctant to spend more than a pittance on educating fund investors.” Why? There’s more profit in an uninformed investor, so education naturally takes a backseat to misleading advertising and marketing campaigns. In what he calls the “Seven Deadly Sins,” Levitt wrote one of the best summaries ever of the fund industry’s widespread and relentless brainwashing of America’s investors. Note how so many of the industry’s sins are designed to create short-term market action—because Wall Street gets rich on buy-sell action, not on long-term buy’n’hold thinking:

First Deadly Sin: High fees are killing your returns
Levitt says the deadliest of all sins is the high cost of owning funds. “Most people would consider a 2 percent annual fee to be quite low, and don’t realize that it is really a punishing levy,” especially when the total return is in the 6-7 percent range. Actively-managed funds are running with a huge handicap, yet their managers won’t tell you that “most researchers have concluded that funds with low expense ratios actually outperform more expensive funds.”

Second Deadly Sin: Funds trade too much, you get the tax-bite
Active fund managers love playing the market, even though they rarely beat the indexes. The average fund turns over their portfolio 122% annually, triggering a lot of tax consequences. But the fund pays no taxes, you do. The fund distributes tax gains from trading to their shareholders, even when the fund loses money. Levitt says one way to increase your returns is to “judge funds on their after-tax, rather than pre-tax, return.” Unfortunately, the funds have refused to publicly advertise after-tax returns, preferring instead to bury the data in their prospectuses along with many other facts that might prove to be too embarrassing.

Third Deadly Sin: Funds fail to disclose important information
The fund industry is keeping investors in the dark about much of their operations: “They don’t want you to know a lot about what goes on behind the curtain at fund headquarters.” They refuse to disclose manager compensation, incentives and other conflicts-of-interest. They bury their mistakes by merging underperforming funds into the more successful ones. Another: Kickbacks known as “soft money, where a fund manager pays a higher than broker’s commission and gets a “rebate” in the form of “research, software and even computer equipment. Who pays for soft dollars? You do. And while they’re supposed to disclose the deals, they usually don’t.”

Fourth Deadly Sin: Index funds beat actively-managed funds
Levitt’s fourth deadly sin is “also the fund industry’s dirty little secret: Most actively managed funds never do as well as their benchmark.” Even with all their super stock-pickers and analysts they “still can’t beat the passive index funds.” In fact, on a load-adjusted basis, “the index funds beat the managed funds by about 1.2 percent a year, a significant amount” over a ten-year period.

Fifth Deadly Sin: Funds mislead by focusing on performance
The fund industry promotes a “culture of performance” as Levitt calls it, “even though it knows perfectly well that it misleads investors.” They know that past performance doesn’t predict the future, yet they “buy expensive ads in newspapers and magazines to tout their performance.” They boast about misleading information while hiding key facts, like management experience and changes. Manipulation? You bet.

Sixth Deadly Sin: Funds preach long-term, but invest short-term
Fund managers “don’t practice what they preach,” says Levitt. “Most say they believe in the merits of long-term investing,” and yet, “the typical manager sells every stock in her portfolio at least once a year.” Levitt even calls them market-timing “speculators,” trying to do the impossible, pointing to a Morningstar study that “found the lower the turnover, the better the performance.” Thanks to this pressure, not only are the insiders, the portfolio managers churning their portfolios, but the holding period of the average Main Street investors has declined dramatically as they turn more to active trading—following the examples set by their duplicitous portfolio managers.

Seventh Deadly Sin: Fund names are misleading
Levitt acknowledges that funds are first-and-foremost high-pressure marketing organizations. In fact, when it comes to the profits made my fund insiders, marketing to increase assets under management is far more important than portfolio management. Unfortunately, says Levitt, “you can’t judge a fund by it’s name.” Not all municipal bond funds have guarantees. A Treasury bond fund may have junk bonds. An “Americas” fund may have Asia stocks. Growth may have lots of tech stocks. And they do this with a straight face—with their hands in your pockets!

Early in the 2002-2004 stock and fund scandals, Levitt put it simple and blunt in a Fortune interview: “America’s investors have been ripped off as massively as a bank being held up by a guy with a gun and a mask.” I’d wish I could say that we learned valuable lessons and things have improved. Or at least that investors are holding their own in this war. Unfortunately, it’s gotten worse.

Yes, “they” are pushing your short-term “buy-button” today!

Warning: Forget all of Wall Street’s spin about being patient and planning for some long-term future. The truth is, Wall Street gets rich on commissions and fees from a short-term action-oriented market. You can’t trust what they say in public. They say one thing and do another—and no matter what they say, Wall Street wants you to think short-term, plan short-term, act short-term.

Bottom line: Wall Street does not want Main Street investors to think long-term, they are constantly pushing your “buy button.” They want you to buy, buy, buy, now, now, now (that is, unless they can lock you into a long-term management contract and charge you excessively high fees for doing little or nothing—while they trade fast and furious using your money, having all the fun of playing the short-term game!)

Update: In mid-2009 Bloomberg New reported that Levitt is now working for Goldman Sachs, offering “strategic advice to the firm on a range of matters,” just as “Federal regulators and lawmakers are overhauling the rules governing financial institutions after firms reported more than $1.48 trillion of write-downs and credit losses since 2007.” In short, the author of Take On The Street now works for The Street.

FirstPubDate: Jan’03

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