Mutual fund follies

The mutual fund industry is battered and bruised these days. The scandal that rocked fund companies in the U.S. has echoed across the border. As of this writing, no Canadian companies have formally been charged, but the Ontario Securities Commission is actively digging into past records looking for evidence of possible skulduggery. 

But that’s not the only problem facing mutual funds. There was growing disenchantment among investors before the scandals broke. The sad truth is the fund industry has been complicit in driving people away by its own practices and built-in conflicts of interest.

During the 1990s, mutual funds became the greatest phenomenon to hit the financial scene in a generation. They offered an enticing combination of easy access, broad diversification and, most appealing, impressive returns. 

Riding the gravy train
For a while, all was rosy. The strong stock markets of the ’90s boosted equity fund returns to levels that, prior to then, ordinary investors could only dream about. From 1991 to 1993, Altamira Equity, a no-load fund that was sold by telephone, reeled off successive annual returns of5 per cent, 30 per cent and 47 per cent.

The money poured in from all directions; the fund’s asset base went from a mere $34 million in 1990 to more than $1.6 billion by 1994. The story across the rest of fund land was very similar. The gravy train continued right through to 2000. Then it ran right off the rails.

What went wrong? Here are some of the answers.

Greed. Both the fund industry and its retail arm, the financial advisory community, began to overreach. By the late ’90s, advisers who specialized in funds were raking in big dollars in commissions. Meanwhile, fuelled by the high-tech boom, fund companies were launching specialized funds focusing on such trendy fields as technology and telecommunications. At the outset, most of these funds chalked up big returns. The more that was invested, the more that went into the pockets of advisers and fund managers.

In an effort to pad their wallets even further, some advisers (although by no means all) aggressively encouraged clients to borrow heavily to invest even more. Home equity lines of credit were the chosen instrument for this purpose. Often, the money was invested in highly aggressive funds on the theory the tech boom would go on for years.

Hitting the wall
Of course, it didn’t. The bear market of 2000-2002 shattered the dreams of many of these investors and left them with huge debts and a mutual funds portfolio that was worth perhaps half its original value. No wonder they became disillusioned.

Conflict of interest. For years, I have complained about the built-in conflicts within the industry. In a nutshell, fund companies and advisers make more money when you invest in equity funds than if you put your savings into bond or money market funds. So there is a systemic incentive for advisers to push equity funds. Not all do so, of course – most recognize that the long-term financial well-being of their clients will produce the best rewards over time. But the temptation is always there.

Loss of touch with investors. In recent years, the load fund companies, which charge sales commissions, have focused most of their marketing dollars on promoting their products to the advisory community – not to the ordinary investor who is, after all, the ultimate client. The philosophy is to convince the adviser who, in turn, will make the sale to the customer.

The problem with this thinking is that many people are bypassing the adviser route and investing directly through discount brokers. So they rely on their own resources to make a decision. The no-load firms, like the banks, recognize this and direct a large part of their marketing toward retail investors. That gives them a higher profile when decision-making time comes. It’s no coincidence that the Royal Bank funds are now number 1 in Canada in total assets.

A broker told me recently his clients don’t even want to hear about mutual funds these days. They are looking at every possible alternative instead.

And what are those alternatives? That’s a subject I’ll be exploring in future columns.