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[Note: The back-of-the-envelope analysis in this commentary has been refined in a paper and a new commentary. I am particularly grateful to Pamela van Giessen who encouraged me to continue pursuing this line of research after reading this commentary. 

The main result of this original commentary (mutual funds are an expensive source of active management) continues to hold; however, using R2 directly to allocate costs tends to overstate the implied cost of active management. The new analysis in the aforementioned paper and commentary uses a portfolio replicating strategy to derive a more rigorous cost estimate.]

Uncle Possum's Handbook of Mutual Fund Scams


Ross M. Miller
Miller Risk Advisors
August 9, 2004

The title of this week's commentary is one of numerous titles that I considered (if only momentarily) before Rigged appeared in a vision as the title for my novel. Readers of that work may notice that the relationship between the two fictional companies in that book, GFF and The Lowell Group (formerly Lowell, Perkins—two big Boston and Harvard names), is not unlike the one that existed between the GE and Kidder, Peabody. Indeed, what fascinated me about GE's acquisition of Kidder (a relationship I know something about) was the possibility that it might have been motivated by a poor Irish kid wanting to get revenge on the Boston establishment. (Kidder, which was the traditional Boston brokerage firm, got its start there before moving to New York.)

Unfortunately, what I do know about that ill-fated acquisition indicates that revenge was very low on the list of reasons that Jack Welch bought Kidder (actually, only 80% of it at first). Still, it makes a nice story even if some facts get in the way. For one thing, while Jack Welch was (according to his autobiography) once an Irish kid, it would be a stretch to call him poor. He was born and raised well north of Boston in the town of Salem, which I would imagine was quite pleasant because all the witches had been driven out well before Jack arrived. For another, while Kidder had once been the ultimate "white shoe" investment bank and broker, to survive in the deregulated world that followed the Golden Age described in the previous four commentaries, it became a more inclusive organization. Indeed, the various scandals that set the stage for Kidder's downfall were associated with individuals that the Kidders, Peabodys, and Thayers who started the firm would have crossed the street to avoid.

The good thing about fiction is that it provides one with the opportunity to build a better Jack Welch as well as a better Kidder, Peabody for him to buy. I will not go into details about Jack other than to say in the interests of common decency the dialog attributed to Mike Quinn, his fictional counterpart, is only lightly peppered with obscenities (and mild ones at that). Kidder's equivalent, The Lowell Group, survived by hiring some dubious Boston's Brahmins so that I could keep its shoes a nice, titanium white. Kidder's business was too complicated for many readers (and some of its own employees) to understand, so I put them in the mutual fund business and moved the firm back to Boston. Any similarity between Kidder and The Lowell Group is more than purely coincidental, it is completely unintentional.

The main reason that Rigged did not become Uncle Possum's Handbook of Mutual Fund Scams is that while the typical reader may harbor doubts about what is going on with his mutual funds, an exhaustive account of how he can be fleeced, while educational, sorely lacks entertainment value. Furthermore, while the scams bandied about in the business press are illegal, the legal ones are not only more interesting, they are more frightening. Anyhow, if I put everything I know in my fictional works, I would have nothing left for these commentaries.

I conceived of Rigged's main mutual-fund scam (which I will not divulge here) while writing Paving Wall Street, a book about experimental finance and the inner workings of the market mechanism. Rigged's scam and the real-world ones that have been making the headlines are rooted in the same, fundamental misconception--that the price that one might (with the blessings of the government and the accounting profession) place on a security reflects the true value of a security, especially if one is in the position of having to buy or sell a large amount in a short period of time. As a result, the stated NAV (Net Asset Value) of a mutual fund can be even more fictional than my novel. Market timers and late traders can turn this fiction into cash.

A far greater problem that mutual funds may face than any scam, legal or illegal, is that they appear to be falling out of fashion. The typical mutual fund can be viewed as a hybrid financial product than has two pieces—a passive piece and an active piece. The passive piece behaves like an index fund based on the index that serves as the fund's benchmark. For more reasons that I wish to enumerate here, mutual funds, especially large ones, tend to drift toward their benchmarks.

Let's start by considering a fund whose name sounds like it swims against the current—Fidelity's Contrafund—which rates five stars from Morningstar. The generally accepted measure of how closely a fund tracks a benchmark is its R-Squared, which indicates how much of the variance in the fund's return is explained by the benchmark's movements. Viewed relative to the S&P 500, Contrafund is indeed an odd fish, with an R-Squared of 69%, which is low for a fund with nearly $40 billion in it. Morningstar does, however, indicate that Contrafund has an R-squared of 83% relative to the S&P Midcap 400. Viewed in this light, out of every $6 invested in Fidelity Contrafund, $5 is invested in an index and $1 is actively managed in the pure sense of having zero correlation with the benchmark. If we take the stated expense ratio of 0.98% as accurate (there are times that it may not be) and consider that the retail version of Vanguard's Midcap Index fund has an expense ratio of 0.26%, then the annual expense ratio for the active 17% comes out to nearly 4.5%. (As they say, the details of this and many other computations described below are left as an exercise for the reader.) With the typical hedge fund charging 2% up front and 20% of any profits, such a fund would have to return 12.5% a year in order to merit an expense ratio that high if it were a hedge fund, which it is not. Contrafund does, as Morningstar computes it, have an alpha of 0.73%, which means that it is beating the benchmark in risk-adjusted terms even if not by enough to justify its expense ratio.

The bad news here is that Fidelity Contrafund is a rather good egg as mutual funds go and still its expense ratio for the active management that it provides (admittedly, calculated in a crude manner) could be considered high by hedge fund standards.

Next, let's consider another popular five-star fund, PIMCO's CCM Capital Appreciation C. (Those who've figured out where this is going should not spoil it for everyone else—just pat yourselves on the back.) This fund has an R-Squared of 87% relative to the S&P 500, which Vanguard Institutional Index tracks for an fee of a mere 0.05%. (This fund is available to individuals through many 401(k) plans.) CCM Capital Appreciation C comes with a hefty expense ratio of 1.85%. This means that one is paying expenses of nearly 14% on the actively managed part of this fund. Our typical hedge fund would have to make a 60% return to rate this large a fee. To many matters worse, the alpha on PIMCO's fund was a negative 3.34. (It was an even larger -9.79% relative to the index that Morningstar deemed a slightly better fit.) This means that if the active part of this fund were a hedge fund, its manager would only get 2%, not 14%, and would risk losing his investors.

Please note that CCM Capital Appreciation C was not involved in the SEC charges of fraudulent market-timing aimed at PIMCO nor was Bill Gross, PIMCO's chief investment officer, who opines in this month's Investment Outlook that the high fees charged by hedge funds make them "generally overpriced."  Bill Gross manages PIMCO's humongous Total Return Institutional Bond Fund, which has an expense ratio of 0.43% and tracks the comparable Lehman index with an R-Squared of 95%. Vanguard has an institutional fund that closely tracks the Lehman index for a 0.05% expense ratio. Therefore, Mr. Gross gets about 0.38% for the active 5% of the fund, which is a "true" expense ratio of 7.8%. It must be said that Mr. Gross delivers an impressive alpha of 0.84 on that active 5%, so he could have a bright future in hedge funds.

I must point out that I have been a nice guy and have not even mentioned the shadow indexers, such as a fund that I will leave unnamed with a 99% R-Squared relative to the S&P 500 and a 0.70% expense ratio. This gives a 65% expense ratio on the actively managed 1%. (And then there's its alpha of -2.22.)

Now, back in my fictional world, readers do not take kindly to paragraph after paragraph of math that shows that as bad a deal as hedge funds might be, mutual funds can be even worse. Readers want entertainment, and so in Chapter 19 of Rigged, entitled "Hedgehog," I have concocted the ultimate hedge fund manager, who provides counterpoint to Bill Gross without using any math. "Hedgehog" will be released at this Thursday and will appear with a brief introduction on this site next Monday in place of the usual commentary. Oh, and the current chapter, "Attraction" is a good place to learn about poker strategy and general relativity. In an entertaining manner, of course.

Copyright 2004 by Miller Risk Advisors. Permission granted to forward by electronic means and to excerpt or broadcast 250 words or less provided a citation is made to