Wolves of Wall Street: How Fund Managers Lie to You

The still-unfolding Theranos fraud trial is a reminder that the investment world is rife with deceit and predatory behavior.

But the dangers to your financial well-being extend beyond outright criminality. Many investment advisers have devised dishonest but legal methods to part you from your money. The stakes are high.

Since the introduction in 1924 of the first mutual fund in the United States, the mutual fund industry has undergone huge growth. According to the latest survey from the Investment Company Institute, the combined assets of the nation’s mutual funds currently total $25.7 trillion.

Today is Thanksgiving and the markets are closed. It’s a chance for investors to take a deep breath and step back from the daily white noise of Wall Street.

I want you to consider the many ways in which mutual fund managers can practice deception. Because let’s face it: the wolves of Wall Street often come to you in sheep’s clothing. They especially prey on your emotions during times of uncertainty.

If you’re worried about your investments in what promises to be a volatile fourth quarter, just remember that passive investors who put their portfolios on automatic pilot will, like sheep, get slaughtered.

I’m generally bullish but the coronavirus pandemic could still throw us a curve ball. No matter what your investment goals or time horizon, you should always apply your own rational analysis when it comes to your savings.

It’s difficult for humans to avoid the herd mentality. After all, they’re social animals and as such, take their behavioral cues from others.

This herd-like tendency is glaringly apparent when it comes to mutual fund investing. The mutual fund, by its nature, attracts investors who like to delegate analysis to others.

Mutual fund investors often believe the myth that they can just leave everything to the fund managers. I can’t really blame these fund managers for perpetuating lies about their investment infallibility, but I can blame you for believing them.

Four Mutual Fund Falsehoods

I’ve put together a list of the most common misconceptions about mutual funds, as well as a checklist for assessing and picking the mutual funds that are right for you.

As you analyze the multitude of mutual fund alternatives, don’t fall for what may be the four most prevalent mutual fund fictions. You probably believe a few of these yourself, but de-program your mind. The following four fallacies are ruinous to your wealth creation.

If your mutual fund manager utters any of these lies… fire him!

1) Because they’re diversified, mutual funds entail little risk.

As with all securities, mutual funds are subject to market risk. No matter how highly you think of the fund management’s expertise and track record, there is no way to predict the future or whether a given asset will rise or fall in value.

2) Mutual funds are always long-term investments, suitable for retirement. Invest in them and forget them, until you need the money.

False! Many fund managers run their respective funds with short-term “beat my benchmark” performance goals in mind. If you don’t regularly monitor your fund and change course when warranted, you could be left with a poor investment.

3) As fund assets increase, mutual fund costs will decline.

For most funds, this has yet to occur. As they’ve grown bigger, many funds continue charging higher fees.

The investment industry continually pushes the lie that the statistical law of large volumes, when applied to mutual funds, will protect the average individual investor from paying too much. The theory says as a fund’s assets expand, each individual becomes responsible for a shrinking percentage of the fund’s fixed costs.

In reality, expenses for many funds have followed only one direction: UP.

4) Taken as a whole, mutual fund returns meet the expectations of investors.

Not true. Indeed, a majority of funds don’t even reach their benchmark index.

Mutual Fund Reality Checks

When looking at mutual funds, apply these four “reality checks” to ensure you understand what you’re getting into. Here are some of the fund characteristics you should scrutinize:

1) The fund manager’s investment strategy and whether or not it is relevant to your investment needs.

The fund manager’s investment strategy can be found in the fund’s prospectus, usually on one of the first few pages. Make sure it’s a strategy that you agree with and that serves your needs.

For example, if you’re invested in a mutual fund for your retirement, the fund should be conservative and suitable for long-term investors.

2) The fund’s expense ratio, also stated in the fund prospectus.

The fund’s expense ratio is its annual operating expenses divided by its average annual net assets. An expense ratio is the percentage of your assets a fund claws back each year as payment for its services. Most analysts consider an expense ratio of 1% or less to be reasonable.

3) Fund performance over three different time periods: the past year, past five years, and since inception.

A manager might get lucky over a short time frame, but if you use longer yardsticks you’ll be able to separate true talent from sheer luck.

4) Portfolio turnover, as stated in the prospectus.

Keep a special eye out for unnecessary turnover within the fund.

According to industry analysts, in recent years fund managers have racked up an all-fund average turnover of about 85%.

In fact, many funds have turnover ratios in excess of 100%. In other words, in the aggregate, managers sold all the shares that they owned at the beginning of the year and bought new ones.

This sort of intense trading exposes you to the twin enemies of investing profits: income taxes and trading expenses. Industry experts estimate that trading expenses sock investors for between 0.7% and 2.0% every year, and income taxes can eat up another 0.7% to 2.7%, depending on your particular tax bracket. Add up all of these hidden costs, and they can take a big bite from your potential gains.

According to some estimates, hidden expenses altogether generate an estimated all-in cost of 4.52% for a taxable investor or 3.52% for non-taxable accounts.

Take care to screen all funds for unreasonable turnover ratios. If you pinpoint a fund that sports a turnover rate of 50% or more, calculate whether its returns are higher than funds with lower turnover rates.

Keep in mind the time periods involved and whether these returns were consistent. If you take the time to look, you can find plenty of low turnover funds that won’t rack up unnecessary costs and fees by “churning and burning” your holdings.

Editor’s Note: Are you looking to exceed the gains of conventional, buy-and-hold stock investing? Consider the trading methodologies of my colleague, Jim Fink.

As chief investment strategist of the premium trading service Velocity Trader, Jim Fink has devised strategies that make money in up or down markets, in good times or bad.

Jim has put together a new presentation that shows smart investors how to earn massive gains in a short amount of time. Click here for free access.

John Persinos is the editorial director of Investing Daily. To subscribe to John’s video channel, follow this link.