Mutual fund companies are in peril
Posted
Oct 24 2008, 03:15 PM
by
Andrew Horowitz
Rating:
How much confidence do you have in your mutual funds? If you are like most, you are looking at your statements - at least the ones that you dare to open - differently than ever before. That is probably because you thought that you had a good level of diversification and had some built-in protection since a professional and experienced manager was watching over your portfolio.
That has all changed now and most investors are totally disgusted and thoroughly dissatisfied with the returns their hard working managers have provided. The problem is now more evident than ever for many of these fund companies and may deserve to be shorted. Here is why...
You are not alone when you look at your portfolio of funds and wonder what happened. Investors are pulling money out of all types of funds at a record pace and mutual fund companies such as Legg Mason, T. Rowe Price Group, Janus, Alliance Bernstein and Franklin Resources are struggling and will continue to struggle on many different levels. As investors have been withdrawing funds due to their dissatisfaction with performance, even the fund company's highest profit margins from money market funds has come under fire. In addition, competition in the form of low cost ETFs is also gaining strength as investors are looking for alternatives. (See "Mutual Fund Companies are Doomed" here)
Most investors have voiced their disgust for their managers by withdrawing funds at a breakneck pace. If we see this fleeing of assets happening in the market place, the question to be asked is: where are people putting their money? Most investors are still too shell-shocked to be willing to place their hard earned cash back into the failing banking system. If they were, we would see banks with stockpiles of cash ready and able to loan to consumers. That has not occurred as we certainly have not seen any significant loosening of the clog within the credit markets.
Money is also not going to be put back into funds. It is going to be a long time until mutual fund managers and fund companies alike gain back the confidence of investors. For too long, fund companies have been charging ridiculous amounts of money for the highly regarded "active management" which has only provided sub-par results.
What was supposed to be a way to diversify has turned out to be nothing more than market returns in a terrible market. If you have been unfortunate enough to follow the wisdom of the buy-and-hold crowd and invested in any of the top 25 mutual funds by asset size, you have certainly seen some historic volatility within your portfolio. Some of the best known managers of our time including Bill Miller of Legg Mason, Chris Davis of Selected American and Kenneth Heebner of CGM Funds, have suffered dramatically this year. Frankly, looking at the year-to-date returns from these managers is absolutely appalling.
Sample of Funds as of 10/23/08
Legg Mason Value Trust (LMNVX) YTD -51.70%
Selected American Shares Fund (SLADX) YTD -38.19%
CGM Focus Fund (CGMFX) YTD -45.93%
American Funds Europacific Growth Fund (AEGFX) YTD -44.62%
American Funds Growth Fund of America (GFAFX) YTD -38.74%
Fidelity Magellan Fund (FMAGX) YTD -50.37%
Indices as of 10/23/08
S&P 500 YTD -37.07%
MSCI EAFE YTD -45.14%
Morningstar Large Growth YTD -39.91%
Morningstar Large Blend YTD -32.89%
Morningstar Large Value YTD -36.60%
These numbers consider the fact that you can purchase the institutional or no-load shares of these mutual funds. If you have any other class such as A, B or C shares you are down even more. This is important to consider because mutual fund companies make money from assets under management. If assets are fleeing and the fund price is declining, then it seems very clear that earnings will suffer.
Money market funds have also been under fire as of late. In fact, according to AMG Data Services, Money Market funds
report net outflows totaling -$133.129 billion in September, the largest monthly net
outflow from the sector on record. General Money Market funds report
record net outflows as well of -$479.204 billion.
Concerns about the possibility of these funds breaking the $1 NAV have been somewhat hushed by government action when they initially guaranteed all money market mutual funds for those invested prior to September 18th. There is still the possibility that funds may have difficulty going forward as commercial paper losses could be far greater than anticipated.
Now, the real concern is that the Fed is providing a total of $540 billion to help try to contain any problems for money market mutual funds. This money, which has everyone wondering how the Fed will replenish from its almost empty balance sheet, could potentially add to the problems of the fund companies. Many are already waiving their fees to maintain as much principal value as possible in order to hold up share value. Now, if this $540 billion requires companies to pay loan interest or other repayment, earnings may be further reduced. This is still a wildcard.
Another problem for funds is that competition from ETFs has become rather intense lately. ETFs provide market exposure to almost any area that you can think of for a much cheaper cost. Although these funds aren't "actively managed" they do effectively track the benchmark that they are being compared to. ETFs don't have short term redemption fees, they allow you to trade intra-day and they provide the flexibility and low tracking error, all of which can be a powerful tool for any investor.
The final realization that fund companies are in trouble will be when 401k administrators take a look at their quarterly statements and hear an earful from the company employees that are suffering. If there is no legislative action that will occur, there will at least be a revolt lead by employees that want more alternatives to help reduce risk. Many of the fund companies will be forced to provide brokerage services or they will be at risk of losing accounts. Money will surely flow out of mutual fund accounts and into the brokerage side, further reducing earnings.
With all of this being said, mutual fund companies should continue to struggle due to lack of confidence in managers, increasing redemptions, commercial paper concerns and increasing competition. Going forward we are not sure how investors will regain confidence with their beloved mutual fund managers, but our outlook is rather bleak. We are seriously in doubt that active management from mutual fund companies added much value to a portfolio. It is time to question why our wealth managers and financial planners still trust several of these faulty mutual fund managers with our money.
The bottom line: There should be a significant share loss for many of the companies in this sector as they will feel the pain of massive withdrawals as the year progresses and there isn't much they can do to prevent it.
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Disclosure: Horowitz & Company clients may have short and/or long positions in securities mentioned as of the date of publish.
Andrew Horowitz is a money manager and the founder of Horowitz & Company. He is also the author of the bestselling book, The Disciplined Investor . Check out his latest investment idea or listen in as he hosts, The Disciplined Investor Podcast. Kevin Hoffman helped compile data for this article.
