Mutual Funds

There are at least two opinions held by the population at large on any subject. In Thailand there is Mr Thaksin's view and the opposite view is often held by academia.
Academics, because of their education and sometimes because of their lofty position, can sound extremely convincing when they interpret national policy opposite to the Prime Minister's viewpoint. Unfortunately for academia the majority of Thai people see things the Premiers way.
This is not a political column this month but I want to look at academia's view of one area in the financial field where the general population sees things differently than our learned friends.
I would like to examine why investors have flocked to mutual funds in spite of the abysmal performance record that academics have ascribed to the industry.
Readers of this column generally have a savings philosophy and will most likely hold a mutual fund of some sort.
According to a study by Roger M. Edelen, the typical mutual fund offers a return after expenses of 1 percent a year lower than a passive benchmark return.
We are talking here about an industry in the US alone of US$7,000 bn.
Roger Edelen asks if mutual funds are unique in their ability to dupe the consumer.
One does not have to look far to find credible explanations for their popularity.
Mutual funds offer a diversified position in just about any asset class you might want to target with as much cheap liquidity as you could ask for.
Consider the alternatives, cobbling together an investment portfolio on your own.
The administrative costs of building a typical fund portfolio of 80 or so stocks from a specific investment objective or asset class would be onerous for any investor.
One must identify the relevant securities, choose among them and execute the trades.
Moreover these costs must be borne each time the investor seeks to alter the investment focus say from small-cap aggressive stocks to high grade corporate bonds.
Shifting in and out of asset classes at any frequency short of a few years would be prohibitively costly to administer without mutual funds.
Admin costs are difficult to quantify but consider this.
Assuming a typical transaction of $20,000, this suggests that around 100m transactions took place in 1999. Executed without the benefit of mutual funds, each transaction would involve selecting a target diversified portfolio of directly held securities, executing 80 purchase trades and 80 sales trades and updating bookkeeping and tax records. Even if these tasks could be executed at a rate of two hours a transaction, which seem optimistic,
We are talking some 80,000 man-years of effort at 50 hours a week. The implied admin savings offered by mutual funds would be US $4bn. assuming an average annual salary of $50,000.
There appears to be 4bn reasons a year for investors to flock to mutual funds irrespective of whether they offer enhanced returns.
Rodger Edelen continues "A typical mutual fund enjoys substantial economies of scale over individual investors in both the administrative and transaction costs of maintaining a liquid diversified position. But offering a liquidity service that amounts to trillions of dollars a year does entail costs for funds. Indeed the academic studies that draw negative conclusions about the returns offered by mutual funds may be painting a misleading picture. These studies assume that fund managers incur zero costs in providing liquidity'.
This of course is coming to a conclusion without considering all of the information
In conclusion we would have to say that Mutual funds perform a variety of services. In particular they offer a liquid position in a diversified portfolio targeting a specific asset class or sector. For most investors this greatly improves their investment opportunities. In particular positions can be acquired and liquidated with minimal costs.
Most holders of mutual funds are not even aware of these benefits so when academics stand up and criticise their performance the average investor feels they have bought a pig in a poke. Think again. And please get your broker to fully explain any investment you ever purchase.