Chapter 7. Seduced by the Dark Side

We begin our discussion of the general problems with mutual funds by considering the environment in which investors must operate when they consider mutual funds as an investing alternative. This environment consists of the popular press, a term that encompasses newspapers, magazines, TV and radio shows, Internet sites, and other distributional media such as CDs or tapes.

Mutual funds are a major financial asset held by many investors, and therefore they are of interest to a large number of people. Newspapers, magazines, and television programs quite naturally are going to devote considerable attention to mutual funds to cater to the ongoing interest in them. The cover stories on many business- related magazines often involve mutual funds, with titles like these:

• "Seven Funds to Own for a Lifetime"

• "Eight Funds to Buy Now"

• "Catch a Rising Fund Star"

• "Core Funds Every Investor Should Own"

The amount of information about mutual funds is overwhelming. Everywhere you turn , a newspaper or magazine has an article about investing in mutual funds. Rankings of funds are a dime a dozen . No one can keep up with all that is written about them. A general problem with mutual funds, therefore, is that all this information is readily available, and it continues to proliferate, month after month.

One thing is certain about the popular press and mutual funds: There is an enormous amount of information out there, in both print form and on the Internet. Most of the major magazines and newspapers carry periodic ratings of mutual funds, including (but not limited to) Forbes , BusinessWeek , Kiplinger's , U.S. News & World Report , The Wall Street Journal , and Barron's . Of course, they regularly carry feature articles about mutual funds, including those recommending particular funds at various points in time. It is a never-ending game: Here are the funds to own now. Six months or a year from now the list will be different, but the message will be the same ”here are the funds to own now!

The Internet provides a wealth of information about investing, and almost all of the major investment-oriented Web sites have a section devoted to mutual funds. Included here are Quicken, CBS Market News, Kiplinger's, Worth, BusinessWeek, Bloomberg, and on and on. The issue is not finding adequate information about mutual funds; it is sorting through the overwhelming amount of information available.

Inevitably, the popular press is reporting on the funds that have shown great results recently, such as the last quarter, the last six months, or the last year. The problem with this is that many of these funds are volatile, or happened to be positioned in sectors that performed well during that period of time ”energy, for example, or technology, or medical care. These funds often do not perform well in the next six months or year. In short, the past does not often predict the future all that successfully.

Yet the cycle repeats itself over and over. Magazines have to sell copies, and what better way to do it than proclaiming a new guru who turned in a recent annual performance of 40 percent, 50 percent, or more? Such headlines and stories capture investors' attention, often much to their sorrow.

By the time you read about a hot fund in the popular press, the easy money has probably already been made. It is often too late for you to jump on board. Other performers will emerge in the future, based on what the overall market is going to do and which sectors of the economy enjoy particular investor favor. Often, following the advice given in the popular press ”in effect, following the crowd ”is the wrong thing to do.

Thus, forewarned is forearmed. But how many investors really pay attention to a disclaimer such as that made by Schwab on its Web site, www. schwab .com (under the section titled "Important Mutual Fund Information"). "Past performance is no indicator of future results. Fund historical performance does not promise the same results in the future."

Investors need to be selective and focus on those sources that are of particular merit and value. The outstanding source of information on mutual funds ” sort of the recognized authority these days ”is Morningstar. In both printed material and at its Web site, Morningstar dispenses a wealth of information about mutual funds. This includes not only factual data ”fees, performance, portfolio holdings, and so forth ”but also ratings, style analysis, and articles. To be serious about mutual funds, you should consult Morningstar at least periodically.

To its credit, Morningstar also includes critical discussions of its own products, including when these items ”such as its rating system based on stars ”are less than totally adequate. This gives Morningstar great credibility.

Regardless of the source of information investors use, the basic problem remains. Many mutual fund investors are caught up in the day-to-day, month-to-month mania over the latest top-performing funds. The media herald the top performers for the last three months, or six months, or one year, and investors often are ready to buy these funds on the basis that such performance is likely to continue. Much of this activity is understandable because the obvious objective information that investors have about funds is their actual performance record.

The popular press, in turn, does not have much more to go on in churning out the stories. Performance records are readily available, and the press can interview fund managers and get their opinions on what is happening. In the final analysis, however, the deadline pressures await, and this week's or this month's stories must go to press; thus the cycle continues. The press feels it is doing its job, bringing the latest information to investors, and investors in turn rely on the press for information and, ultimately, one way or the other, recommendations.

The end result of all this is that investors often do not get beyond a superficial analysis of the situation. How likely are the top-performing funds to continue to be top-performing funds? Can actively managed funds really expect to outperform index funds over longer periods? How does a particular mutual fund fit into the investor's overall financial plan?

Investors must step back for a moment and look at the situation objectively. Who has a vested interest in keeping the cycle going? What does the record actually show about mutual fund performance over time? How well have index funds performed relative to actively managed funds? What are the chances of buying the actively managed fund that will outperform others in the future, as opposed to buying the one that outperformed others in the past?

Insights

This is the reality: Almost all mutual fund companies concentrate on asset growth because their earnings are a function of assets under management. The companies are going to push the investment style that is currently popular, by creating new funds and promoting them aggressively. In 1999, for example, it was technology funds. This aggressive push often has disastrous consequences for investors. Simply recall the horrific decline of technology funds in 2000 and 2001 to realize the truth of this statement.