Some will use half-truths to discredit mutual funds

Presentation employs old `sample bias' tactic

Dollars & Sense

February 24, 2002|By Pat Dorsey | Pat Dorsey,MORNINGSTAR.COM

I get a lot of e-mail, and unfortunately I don't have enough time to respond to most of it. However, a recent missive from a Morningstar reader (let's call him Larry, since he'd prefer me not to use his real name) got me so steamed that I'm going to answer it right here.

Larry was recently given a sales presentation by some brokers from a large, respected brokerage firm. Their pitch was that mutual funds have "total costs" much greater than the expense ratios that are commonly advertised - often in the neighborhood of 3 percent to 4 percent. They suggested that Larry move his money into individual stocks with their firm, so he would "have more control."

In a standard sales tactic, these gentlemen then slammed their potential competitors by claiming that "anyone can call themselves a financial adviser and just get all of their information off of the Internet." They further warned Larry that he should "stay away from anyone other than the `Big Five,' because they won't have the research budget for analysts or a representative on the floor of the NYSE."

There are so many misleading statements and half-truths in this sales pitch that I barely know where to begin. Let's start with the most blatant misrepresentation, which is that the "typical" mutual fund costs 3 percent to 4 percent per year. As with most fibs, there's a kernel of truth to this: The expense ratio advertised by funds does not include certain costs that are a drag on portfolio performance - mainly trading costs. (Since funds often need to buy and sell in big volumes, they can also have "market impact" costs caused by the fact that their buying and selling can actually move the market. Bid-ask spreads also come into play here.)

But to state baldly that funds "really" cost 3 percent to 4 percent is flat-out wrong. Trading costs are a drag on performance only in relation to a theoretically frictionless portfolio. Any real portfolio making actual transactions in the market is going to incur some kind of trading cost, and the only way to completely avoid bid-ask spreads is to not invest. The two key things to understand are that in a mutual fund trading costs are not money skimmed off your account, and that higher turnover is one of the biggest drivers of higher trading costs.

And wouldn't you know it, in a handout they gave to Larry these brokers chose funds with extremely high turnover to represent the "typical" no-load fund. (The handout was also at least 4 years old, since it referred to Dean Witter funds that long ago were given the Morgan Stanley name, but I suppose the brokers were too busy going on sales calls to update the numbers.)

This is called sample bias, and it's the oldest trick in the book: Show someone a bunch of numbers that purport to represent a typical something-or-other, when in fact the numbers are based on a very skewed subset of a larger group.

It's worth noting the brokers' ulterior motive for pumping up the costs of fund ownership. Their fee-based account charges 2.25 percent of assets, a price that's not competitive against funds with low expense ratios and low turnover, which cost between 0.6 percent and 1.6 percent. But against "typical" funds with "actual" costs of 3 percent or 4 percent? What a deal they were offering Larry! Of course, these brokers weren't tacking on any trading costs - like bid-ask spreads - to the price they were quoting, but anything to make the sale, right?

And as for the claim that "anyone can call themselves a financial adviser?" Well, anyone can call themselves a doctor, too, but you probably wouldn't take a prescription from someone without a medical degree. Same goes for financial professionals. Most financial planners have a CFP (certified financial planner), ChFC (chartered financial consultant), CPA (certified public accountant) or related professional certification, and any smart investor will check out a potential adviser's credentials and references before entrusting them with assets.

Finally, I love the claim made to Larry that he should stay away from anyone other than the "Big Five." Having worked for a couple of brokerage firms in the distant past, I can tell you flat out that bigger doesn't mean better. Sure, "having a rep on the floor of the NYSE" might get you a better deal if you're trading 10 A shares of Berkshire Hathaway, but I can't imagine that a big brokerage firm can consistently execute trades at a much different price than a smaller firm. And if you're not trading all that often, what difference does an eighth of a point now and then really make for a noninstitutional investor?

For all I know, these brokers who plied Larry with a bunch of half-truths could be budding Peter Lynches, and paying them 2.25 percent of assets could be the greatest deal in investment history. The point is that it would be a gamble, since these gentlemen have no track record, and having them manage your money wouldn't necessarily be cheaper than investing in a portfolio of solid, low-cost mutual funds.

At the end of the day, there are smart brokers, smart planners and smart fund managers - and plenty of dumb members of each group, too. Whether you choose to invest in funds or stocks is up to you, as is the decision to use a broker, use a fee-only planner or do it yourself. None of these strategies is inherently better or cheaper, and you've got to weigh the merits and costs of each.

Just don't make the decision based on bad information. If someone's trying to sell you something, and their numbers don't smell right, they're probably not. Do what Larry did and investigate before you invest.

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