The Investor’s Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do about It (a review)

The average investor in an equity mutual fund earned an annualized return of 5.8 percent over the 1996–2005 period versus 9.1 percent for the S&P 500 Index.¹ This statistic alone makes a prima facie case that, as the author of The Investor’s Dilemma: How Mutual Funds Are Betraying Your Trust and What to Do about It contends, mutual funds are not being run for the benefit of investors. Louis Lowenstein, the Simon H. Rifkind Professor Emeritus of Finance and Law at Columbia University, marshals voluminous research to indict the mutual fund industry for straying from the customer-oriented ideals with which it was launched more than 80 years ago.

Lowenstein shows that transaction costs and fees, although higher than they should be, do not fully explain why so little of the underlying stocks’ returns reach fund shareholders. He argues that the fundamental problem arises from fund managers’ determination to maximize assets under management (AUM) in order to capture the attractive economies of scale that the business offers.

A cornerstone of mutual fund companies’ asset-gathering strategy is market segmentation, a technique previously perfected by consumer goods producers. Management firms offer a dizzying array of funds concentrated in categories, such as large-capitalization growth, mid-cap value, and small-cap international, as well as industry and country funds. The role of portfolio managers is to avoid “style drift” by staying strictly within their designated silos. Suboptimal investment performance is an unavoidable consequence of this approach to fund management, in Lowenstein’s judgment. Investors would capture far more of the market’s inherent return, he says, if portfolio managers operated under broad mandates with discretion to pursue relative value wherever it might appear.

In the early days of the mutual fund industry, the inherent conflict between maximizing AUM and achieving the highest possible return for investors was kept in check by the prevailing industry structure and legal doctrine. Fund management companies were small, private firms that were barred from selling their own shares to outside investors. The U.S. SEC deemed the “excess value of the management contracts” an asset of the mutual funds themselves that, as such, could not be sold for a profit by the owners of the management firms. A 1975 amendment to the Investment Company Act, however, legalized such sales.

Lowenstein maintains that as soon as management firms got the chance to go public or sell themselves to major financial institutions, their focus shifted. Instead of trying to deliver long-term performance through the patient, Graham and Dodd approach that Lowenstein favors, they turned to hawking inferior, narrow-gauge funds to exploit consumers’ weakness for the flavor of the month. Funds that beat the averages were advertised heavily—but tended to perform poorly following the resulting influx of new assets. Hiring a broker to help pick the best fund proved to be no panacea for investors because of monetary inducements that potentially compromised the broker’s independence. One study indicated that broker-selected funds have performed significantly worse than funds purchased without a broker.²

The devastating critique in The Investor’s Dilemma deserves the attention of every fiduciary who deals with individual investors. As the author acknowledges, however, mutual fund companies are powerless to reform the business because the U.S. Congress has opened Pandora’s box by allowing them to cash in on their management contracts. It is up to investors to extricate themselves from their predicament by ceasing to chase the fads represented by the overly specialized funds. Mutual fund companies can hardly be blamed if people approach their investment decisions with, in Lowenstein’s words, “an attitude of childish trust, even of naiveté.”

An encouraging sign that at least some investors have recognized the problem is the long-run growth of no-load index funds. These vehicles enable investors to capture nearly all of the market’s inherent return with minimal fees skimmed off the top. Index funds deliver this benefit without requiring nonprofessional investors to achieve what few professionals can, namely, identification of tomorrow’s superior managers. A weak point of the book, however, is that, although Lowenstein concedes these advantages, he clings to his preference for value funds. His argument boils down to the truism that an investor who uses an index fund improperly can fare worse than one who exploits a value fund with exceptional deftness .

Lowenstein’s case is also vulnerable in light of a second major point. The “unseemly profit” that mutual fund companies allegedly extract from their customers is exemplified by the 80 percent return on net tangible operating assets that T. Rowe Price recorded in 2005. If the industry is truly as profitable as all that, why have not more competitors entered the business and driven down margins? The human capital–related barriers to entry cannot be very high if—as Lowenstein documents—relentless marketing can pull in billions of dollars of assets despite mediocre investment performance.

Obtaining a true picture of the mutual fund industry’s profitability requires nonstandard accounting. Under U.S. GAAP, which is fundamentally designed for manufacturing rather than service businesses, expenditures on tangibles are capitalized and then expensed over multiyear periods. In contrast, expenditures on marketing and organizational development generally are expensed , even though they also create value that endures beyond the current accounting period. It is hardly surprising that after writing off most of the investment it has made in its business, a mutual fund company reports a return on its GAAP assets that most manufacturers can only dream about. A start-up, however, cannot come close to replicating the established firm’s net income with an outlay as tiny as the amount carried on the incumbent’s balance sheet.

Turning from accounting to economics, the author errs in asserting that only in the stock market do rising prices sometimes cause demand to rise rather than fall. This effect, known as the “price–quality inference,” is well documented in markets for a variety of goods. In fact, Lowenstein contradicts himself on this point by noting that economist Paul De Grauwe has likened stocks to Belgian chocolates, a product for which consumers equate high prices with high quality.

Certain other imperfections of The Investor’s Dilemma are less momentous but, nevertheless, worth mentioning. For instance, Lowenstein perpetuates the myth that career criminal Willie Sutton said he robbed banks because that is where the money is. In addition, credit for the remark “Prediction is very difficult, especially if it’s about the future” belongs not to Danish physicist Niels Bohr but to his countryman, humorist Robert Storm Petersen (“Storm P.”). Finally, the tale that concludes with the line “This too shall pass” is not a Greek legend.

Lowenstein aims his book at a general audience, but he is to be congratulated on also providing professionals with valuable insight into the money management business. Equally laudable is his insistence on a high ethical standard that is focused squarely on client interests. Lowenstein’s views on this subject are summarized by a remark of fund manager Jean-Marie Eveillard that he quotes. Criticized for adhering to his value stock discipline despite soaring prices for soon-to-crash dot-coms, Eveillard replied, “I would rather lose half my shareholders than lose half my shareholders’ money.”

—M.S.F.