For example, the typical mutual fund turns over its entire portfolio at least once per year and owns 160 stocks. These are two things that often lead to mediocrity: Too much trading and too many stocks. (Nowadays, investors even flip the funds. Forty years ago, the average holding period was 14 years. Now, people flip funds every few years.)

All that churning fattens the brokers of the funds. And the funds often have unseemly arrangements to direct commissions to brokers who help market the funds. Owning all those stocks also means the fund managers often know little about what they own.

No individual stock matters much, nor does any single issue make much of a difference, so why bother looking at any of them in detail? It is little wonder the typical mutual fund puts in such an indifferent result.

But there is much more…

I’ve written about this topic broadly before, but a new book by Louis Lowenstein (The Investor’s Dilemma) really hammers these points home — along with some new ones. This is a book that will make your blood boil. You shouldn’t buy another mutual fund until you’ve given the ideas in this book some thought. I’m going to highlight the most important ideas for you in this section, and we’ll also look at some things you should look for in a mutual fund.

To begin, the individual investor is in quite a pickle. Lacking the necessary time, interest or aptitude for investing in stocks, he or she often looks, naturally, to professionals. Usually, this means tucking some money into a mutual fund.

But where to begin? The number of mutual funds out there grows like kudzu. There were 300 in 1980. There are over 4,800 today. Fidelity alone has over 300 funds, in 24 different flavors. You’ve no doubt seen the absurd slicing and dicing of mutual funds — mid-cap growth, small-cap value, large-cap blend, etc., etc. These are pointless distinctions. An investor should go where the value is — no matter where it is or what it’s called.

These mutual funds are huge forces in the market these days. They own one out of every four shares of stock out there. It was only 8% as recently as 1990.

The reason there are so many — and why they are so large — is because running money is extremely profitable. A lot of brainpower goes into figuring out how to get your money in a fund.

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As becomes clear by reading Lowenstein’s book that most fund companies have little interest in how well investors actually do in their funds. Instead, mutual fund companies are most interested in growing the amount of assets they manage. This is how they get paid.

Lowenstein runs through the example of T. Rowe Price, which is generally held as one of the better fund houses. T. Rowe earns a net profit of 28% after taxes.

“It’s difficult to think of many legal businesses with comparable returns,” Lowenstein writes.

Now it becomes clear why Fidelity has over 300 funds. “Fidelity is a marketing construct,” Lowenstein writes, “not something fashioned to enhance the welfare of investors.” Lowenstein also points out that mutual fund groups spend more on marketing than they do running the funds.

Best Place to Be — Managing Funds, Not Investing in Them

So it’s not hard to understand why the management companies make all the money. Instead of investing in T. Rowe funds, you’d have done better investing in T. Rowe itself. Paul Samuelson, the famed economist, had a pithy quote on this: “There was only one place to make money in the mutual fund business, as there is only one place for a temperate man to be in a saloon: behind the bar and not in front of it.”

This is something the insiders understand well. Lowenstein goes through many examples. Brian Rogers, chief investment officer of T. Rowe, is one. Has only $1 million in T. Rowe’s funds. By contrast, he has $65 million in the management company. Again, he is not alone, nor is this at all atypical. Lowenstein has many more examples.

In the old days, there was no management company. The mutual fund was a true trust. The first open-end mutual fund to arrive on the scene opened its doors in Boston in 1924. A securities salesman named Edward Leffler hatched the idea, which Lowenstein calls “a uniquely American contribution to finance.” The Massachusetts Investors Trust (MIT) was the first of its kind anywhere in the world.

MIT held stocks for a long time, bought stock intelligently and had extremely low costs. There was no management company and no incentive to bilk shareholders. Today, investors accept 1% management fees as reasonable, even if assessed on billions of dollars of assets. This despite the fact that cost of managing money does not rise anywhere near proportionally with the funds invested. Fees should go down as funds get larger, although this almost never happens.

Over many years, the old MIT standard died out. The new way of doing things meant setting up a separate management company. Now fees suddenly skyrocketed.

In any case, the mutual fund industry is a mess today, filled with people just looking to keep pace with some benchmark. Are real estate stocks too high? Doesn’t matter if you’re running a real estate fund. You buy real estate stocks. All you gotta do is beat your benchmark. Even if it goes down 25% and you go down 20% — that’s success in today’s world.

It’s a sorry state of affairs. One fund describes in its shareholder letter a “fundamental…bottoms-up investment process” in a year when the fund turned over 305%. Again, this is not an outlier or hard-to-find example.

All this flipping means the old art of security analysis is dying. Few look through filings anymore. Nowadays, there is too much focus on what the price is doing. There is not enough on how the underlying business is doing. And there is this fetish about liquidity — the ability to buy and sell easily. Suffice it to say that if selling stock were more akin to the process of selling a house, investors would pay more attention to the details of what they were buying. I always think of Peter Lynch’s great quote:

“Investing without research is like playing stud poker and never looking at the cards.”

Too many funds invest without looking at the cards. But again, why bother when you own hundreds of stocks?

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Tips for Finding Good Funds

There are exceptions, though. There are some good mutual funds. Here are some helpful points to help you find them:

• Look for a small portfolio. The exact number is hard to say. Robert Rodriguez, a great fund manager, says 30-40. Joel Greenblatt says 32 stocks take out 96% of the risk of owning one. There is no right number, I imagine, just as there is no “right” amount of tequila in a margarita, but it probably lies somewhere in that range.
  
• Look at the turnover rate. You can find this info with the performance data. A low turnover rate would be something like 25% or less. That implies a holding period of four years.
  
• The fund should not be too large. The American Funds’ Growth Fund of America has $190 billion — way too large to meaningfully invest in anything but the biggest companies. “The damage that size does to performance is the dirty little secret of the fund management business,” says Jeremy Grantham. As a rule of thumb, I’d say less than $20 billion. Rodriguez capped his fund when it approached $2 billion. Again, the right number is hard to say, but it’s somewhere in that range.
  
• The intangibles are also important. Good fund managers often write good letters to shareholders, explaining their philosophy, talking about successes and failures. If you see boiler plate-type language, that’s not a good sign. Again, managers matter.

“True safety lies in a research-driven search for opportunities,” Lowenstein concludes. I couldn’t agree more. He points out how money management is often a “soulless business” in which people “don’t really enjoy the challenge of searching here and there, far and wide, for the values that have escaped the crowd.”

There are exceptions. “However, there are a few who not only take the challenge, but find a sense of self in doing the best they can for clients.”

The vast majority of my money is in stocks. I currently own only two mutual funds: the Fairholme Fund (MUTF:FAIRX), run by Bruce Berkowitz, and the Third Avenue Value Fund (MUTF:TAVFX), run by Marty Whitman. There are other good ones — Lowenstein talks about some in his book, and I have a list in my book Invest Like a Dealmaker. Some to consider in addition to Fairholme and Third Avenue are CGM Focus (MUTF:CGMFX), Longleaf (MUTF:LLPFX), First Eagle and FPA.

Otherwise, better to put together your own mutual fund, using resources like you’ll find here to help your decision-making.

Sincerely,
Chris Mayer

Source: Don’t Buy Another Mutual Fund, Until You Read This

Six weeks or so ago, Fortune ran a cover that blazed “America’s Hottest Investor” – with a major emphasis on “hottest.” The subtitle read, “With a 24% annual return over the past decade, this mad genius is arguably the best fund manager of our time.” (You can read the Fortune piece here.)

I first came across Ken Heebner, long known as “the mad genius of mutual funds,” about three or four years ago. While most of my heroes are lone traders and hedge fund guys, as opposed to mutual fund guys, Heebner is the one amazing exception.

And speaking of amazing, how does a mutual fund guy rack up 24% average annual returns over a decade? That would be no small feat in the midst of a full-fledged bull market. To do it in the 10 years that just passed — a time in which the broad market has mostly just thrashed around — is little short of amazing.

Heebner, who runs a little over $7 billion in his flagship CGM Focus fund (CGMFX), is nothing like your average mutual fund manager. (If he were, he wouldn’t be racking up such stellar returns.) There are at least four things the “Mad Genius” does that 99% of his peers don’t. Here they are in a nutshell.

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First, Heebner likes to think top down rather than bottom up. He is always focused on the major trends, trying to put the puzzle pieces together. (Sound familiar? That’s what we do here, too.)

“Ken is one of the best big-picture thinkers I’ve known,” says Chuck Clough, the former chief investment strategist for Merrill Lynch (NYSE:MER). “He does the research, and he’s got the courage of his convictions.”

Second, he is willing to go short as well as long. He can make money when markets are going down as well as up. This is a major advantage, especially in markets like the ones we’re in now. I’ve always thought that a long-only restriction is the equivalent of playing the game with one hand tied behind your back. While most Wall Street types pooh-pooh the short side, Heebner’s track record shows the value.

Third, Heebner is a true contrarian. Many of his biggest wins have come by taking stances that Wall Street doesn’t agree with. While most self-styled contrarians are little more than smart-alecks who like the sound of the word, this guy is the real deal. He loves being the odd man out. In his own words, Heebner says he is happiest “when everyone thinks I’m nuts.”

Last but not least, the mad genius isn’t afraid to make big bets… to really load up the boat when he knows he’s right. Back in 2006, Heebner revealed the essence of his method:

My huge outperformance occurs when I find one of these very contrarian strategies — something supported by a lot of deep analysis — and implement it in a concentrated way in the portfolio. Like investing in oil in 2004, when everyone thought it was going back to $25 a barrel. Or buying savings-and-loans in 1982, back when interest rates were 15%. I wish I could find one every year, but I can’t.

Along with many other great investors, Heebner believes that diversification is a hedge against ignorance. To really hit the ball out of the park, you have to concentrate your knowledge… and then concentrate your positions. It’s not a game plan that works for everyone. But then, that’s exactly why there’s so much profit in it.

There is one more investing lesson Heebner taught me a few years back… amusingly enough, one that intersects with my experiences at the poker table. I’ll tell you about that one tomorrow.

Source: Four Lessons From the Mad Genius