The Truth on Mutual Funds

Running a mutual fund is more art than science. Unlike banking services, money management is not a commodity. Or at least, it shouldn’t be. While it’s fairly easy to measure the performance of an ATM machine or a checking account, all you have to ask is, “Did my money come out?” and “Did my check clear?”—how do you measure the performance of a money manager? Is it by absolute returns? Or do you use risk-adjusted returns? Do you give more credit to a fund manager for beating the S&P 500 by a wide margin in some years? Or do you give more credit to a fund manager who never trounces the market but never loses to it either? In the mutual fund industry, you’ll sometimes hear the term “stewardship” tossed around. That’s an old-fashioned word that refers to the fact that funds must act with the investors’ interests foremost in mind.

The Investment Company Act of 1940, which ushered in the modern mutual fund industry, explicitly states that funds must act in the best interest of shareholders, as opposed to, say, investment advisers. But what does stewardship mean? And more important, how much is good stewardship worth?

Funds with the lowest expense ratios tend to perform better than average. Financial Research Corp. studied five different categories of mutual funds. Each category was divided into 10 segments, based on the fees they charge. In the vast majority of cases, funds that ranked in the cheapest decile for fees performed better than average over time. If you want further proof you can view this and more from Matthew Goldhaber, Oak Brook.

Let’s say you invested money in a stock fund with an annual expense ratio of 4 percent, which is about three times more costly than the average fund. And assume that this fund lost 20 percent in the recent bear market. Though this is a sizable loss, let’s say you’re satisfied because you lost less than the broad stock market, measured by the S&P 500 index of blue chip stocks. The question some would ask is: Was the fund’s “stewardship” the fact that it steered you to smaller losses in a bad market—worth its steep fee? This is the wrong question to ask. It’s silly to wonder whether a fund’s demonstration of stewardship earns it the right to demand steep fees. In my mind, it’s just the opposite: You have to question whether a fund that charges steep fees to begin with is acting like a good steward. Stewardship doesn’t just mean picking stocks that are in the best interest of shareholders. It means running the entire shop in the best interest of shareholders.

Similarly, we all have to be good stewards of our own affairs. In addition to demanding good service and advice from our financial institutions, consumers need to reduce the amount of money they lose every year to financial service fees. Wherever possible, strive to avoid fees that are clearly unnecessary, like late payment fees on credit cards and ATM charges. Moreover, avoid those costs that are detrimental to the long-term performance of your investments.

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