Wing Collar: Avoiding an Investor Trap

By MARTIN HUTCHINSON, UPI Business and Economics Editor  |  Sept. 19, 2002 at 7:07 PM
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WASHINGTON, Sept. 19 (UPI) -- "The Great Mutual Fund Trap" is what investors fall into if they buy actively managed funds with substantial management fees, according to Greg Baer and Gary Gensler in their new book of that name (Broadway Books, $26.)

Baer, former assistant Treasury Secretary for Financial Institutions in the Clinton administration, and Gensler, Under Secretary of the Treasury 1999-2001 (and advisor to Sen. Paul Sarbanes, D-Md., on the recent Sarbanes-Oxley Act, rooting out corporate fraud) know what they're talking about, being veterans of the Fed and Goldman Sachs respectively. They came by the UPI offices Thursday.

They wrote the book as "consumer advocates for the average American investor" and the basic thesis of the book is that investors spend too much money and take too much risk chasing higher returns, falling into the trap of brokers and actively managed mutual funds, spending of the order of $70 billion per annum in unnecessary money management fees.

"In a nutshell, we overvalue expertise as investors." The book explores in "every imaginable avenue, stock picking, and how Wall Street and the financial media are complicit in this hope and prayer that you can beat the market, when on average you can't" Thus a smart investor will buy an index fund, looking primarily at the charges levied by the fund, and will pick a fund such as one of the Vanguard index fund where charges are low.

Baer and Gensler strongly subscribe to the benefits of diversification and believe that, whether or not Wall Street is a random walk, an individual investor cannot capture any inefficiencies there may be, because it requires them to trade too frequently. In addition, it makes sense to diversify about 20-25 percent of an investor's stock portfolio (provided it's big enough -- say $10,000 or more -- to do so) outside the United States, to a broadly diversifies international index fund.

The book tries to explore "every possible way people try to pick a mutual fund," and has fun looking at "hot stocks," market timing, the Wall Street Journal 'darts versus pros' competition and other methodologies. You end by discovering that the only things that matter are keeping costs down and diversification.

The book even examines the track record of legendary investor Warren Buffett, and discover that, at least since he wound up his closed end mutual fund in 1969, Buffett has been a leveraged investor in the market (borrowing money by buying insurance companies) and an active manager of businesses, so that his track record cannot properly be compared with that of a mutual fund manager.

Other successful mutual fund managers' track records, such as that of Legg Mason since 1990 or of the Fidelity Magellan Fund in the 1980's, are simply analogous to tossing a coin repeatedly. If the chance of beating the averages is 1 in 2, then there is likely to be one fund out of the 3,000 existing in 1990 (since 2 to the 11th power is 2,048) that manages to beat the averages for the next 11 years.

Baer and Gensler have two particular investment tips that I hadn't heard before. The first is "Exchange Traded Funds" (ETFs), which are baskets of stocks matching the major indexes, traded on a stock exchange. They are offered by a number of companies, such as State Street, Barclays and Vanguard. Because the funds are traded on a stock exchange, an investor who buys and holds them does not pay capital gains tax on the underlying purchases and sales in the fund, unlike a buyer of a regular open ended mutual fund. On the other hand, because third parties can create ETF units, or redeem them by exchanging them for underlying stocks, the ETF prices remain very close to their underlying value, unlike the prices of closed end mutual funds, which can trade at a substantial premium or discount to their underlying values.

The second is "Section 529" plans for saving for college expenses. Under these accounts, which are run by the individual states under a 1996 Federal tax law, investors can put aside up to $10,000 a year for college expenses, which will then be placed in an account run by a fund manager on behalf of the state concerned, accumulate profits free of federal tax, and allow withdrawal of funds free of federal tax when the student goes to college.. Anybody can be the beneficiary of a 529 account, you don't have to live in the state concerned, and you don't have to go to college in the state concerned -- although some states such as Virginia give state tax benefits for saving in the local state account. Baer and Gensler have examined the Section 529 plans of all 50 states, and in their view ... (close your eyes if you don't want to read the secret of the plot!) ... the best is Utah, which puts the money in the Vanguard Institutional Index Fund, and charges only ¼ percent management fee on top of Vanguard's low fees. Non-Utahans can invest in the Utah plan, and you don't have to send your kid to Brigham Young!

It's a good read. More important, it's good advice!

(Wing Collar is a bi-weekly column of personal finance advice, expected to appear alternate Thursdays. It intends to give readers the solid financial advice, tailored for today's financial needs and markets, that a wing-collared bank manager would have given in the days before bank managers were salesmen.)

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