By David Barol, CFP
Variable annuities have taken their knocks in the press of late because they impose charges and fees in addition to the expenses imposed by the managers of the underlying funds. Why pay money to an insurance company to gather together mutual fund clones called subaccounts, when one can buy the actual mutual fund? But like any slippery slope reasoning, the logic does not end there. The argument continues in the minds of some who then question, “Why pay any manager to put stocks (or bonds) together in a mutual fund, when it is just as easy to own the underlying stocks direct?”
Whether to hold the stock, or the fund that holds the stock, depends on how much money one has to invest, one’s tax status and what one wants to do with the money. Some people object to “managed money” because it adds another layer of people who exact a fee. If Coca-Cola consistently goes up 20 percent a year, why pay a money manager to hold Coca-Cola?
An efficient market means the price reflects the stock’s value. Value investors, like Warren Buffet, believe that markets are not always efficient. Attention K-Mart shoppers, there is a Blue Light special on aisle nine. Are the oceans in the Southern Hemisphere higher than in the Northern? Or does water seek its own level? Can there be bargains in an efficient market? If markets are perfectly efficient, then given any degree of risk, the returns should be equal. And if this is the case, then with the information available on the Internet, any investor can make as informed a decision as any other. And with the on-line trading capabilities, again on the Internet, all the middlemen are now expendable. The first group the Bolsheviks destroyed was (not the lawyers, that’s Shakespeare) the middlemen. So, away with the brokers; away with the fund managers too.
In an efficient market, no single investor can affect the price of a security. In reality: “Oh, right, that never happens.” When Warren Buffet, or other managers of top funds, buy a significant percentage of a company’s stock, the price of the stock will rise in anticipation of this purchase as well as in the aftermath, as other buyers follow in the wake of the big players. The rest of the individual investors are so far back, they do not even know when the action began.
A mutual fund is an example of a middleman. It buys a product (stocks or bonds) that any of us could buy directly from the original seller. Then this middleman repackages the product, spews a lot of paper in the form of prospectuses and marketing materialof which we ultimately pay for in the expenses of the fund—and then tries to convince us we are doing better than buying direct.
What is a mutual fund? It is a collective, of sorts, in which people have banded to pool their resources. But unlike an agricultural collective in ol’ Siberia, this pool of resources is not run by The People, but by professional managers, just like a Western capitalist business. (And history has already settled that debate.) These managers claim to posses a greater skill at selecting the underlying investments and, because of their greater buying power, can afford to buy more of the products or a more diversified product line than most of us could as individuals. The point they make is that sure, you may be able to buy the same stocks cheaper, but you would not have bought the same stocks at the same time we did.
If markets were perfectly efficient, and if research did not make a difference, then relative fund performance would be based on chance. Throw enough balls at the basket and some will fall in. TV’s 60 Minutes runs a story about a drug for impotence and the pharmaceutical’s stock doubled in the next week. That was easy. As an individual investor, just watch TV. Nevertheless, people who earn their income following drug stocks not only know whether the drug will perform before Mike Wallace does, they know when the story will break on TV.
Information in an efficient market occurs randomly. There is some truth to this (at least in investing) since no one can know which company may patent the next cure for hair loss (a personal concern) or get hit with the next class action law suit. And yet, some would argue that although information may be random at its outset, its development is sequential. Stories have a beginning, middle, and ultimately, an end. Sometimes hearing the news and acting on it first provides an advantage. Sometimes having the wisdom not to react will prove more successful. Sometimes it helps to know the people releasing the information in the first place. Wisdom comes from making mistakes and then learning from those mistakes. These lessons can be expensive, especially for someone using their own money, and even at that, as a hobbyist.
The managers are people, like you and I. Maybe they are no smarter than we are, but they do have the time and money to find the garage in Palo Alto where two geniuses are presently working on the equivalent of the next personal computer. They are more likely to find out which companies in Malaysia or Tibet will grow and which some crazed separatist might blow up. Efficient markets require that access to information be, if not free, at least equal. Fund managers claim their information is not random, but the result of well-developed methodologies and access to information, which although public enough to avoid security violations, is too fresh to be widely disseminated.
Which leads us back to mutual funds (or the sub-accounts offered in variable insurance contracts). Depending on the study, it takes as little as eight stocks and as many as 50 to diversify away company risk. That is the risk that management might do something stupid. Some people can afford to buy eight stocks in an industry or 50 in an asset class. They have the time and the money to do this. Holding this many companies will require costs for multiple transactions and time for tracking, following, measuring. Others, however, if faced with the reality of what it takes to diversify against company, management or asset class risk, will tire of the effort.
Which leads us back to mutual funds. If you believe in perfectly efficient markets and that there is no truth to the herd mentality and research does not matter and there is no Value to be found, then you can do as well as the next guy. But even if you reached this point unmoved, do you believe the people running the companies are smarter than the people managing the funds? If not, diversifying against company risk (i.e., stupidity) has merit. The easiest way to do that is through managed money.
Buy stocks, buy bonds—but not because you have discovered the secret to wealth.
David Barol, CFP, is an investment adviser representatitive in Radnor, PA offering financial planning and secruties through 1717 Capital Management Company, a Registered Investment Adviser, member NASD, SIPC.