The level of dissatisfaction with wrap programs based on mutual funds has reached a new zenith. Underperformance has been remarkably broad, consistent and durable. Solutions do exist and are based on cures for the very specific, inherent weaknesses of mutual fund wrap. Let's explore several of these weaknesses.
First, due to their unique legal structure, mutual funds must incur certain expenses not experienced by other investment solutions. These include the cost of maintaining mutual fund accountants, administrators, boards of directors and auditors. Separate accounts avoid these four incremental cost burdens.
Second, due to mutual funds' commingled structure, they experience significantly higher levels of portfolio turnover than would otherwise be the case. Each day, mutual funds realize cash inflows and outflows from arriving and departing shareholders. During times of high emotion (either fear or greed) these flows can become quite substantial. In fact, they became overwhelming during the tech-wreck of 2000. The portfolio manager accommodates such cash flows through the realization of higher portfolio turnover. The Plexus Group (one of our industry's most experienced trading-cost analysis firms) estimates turnover costs at 898 basis points for small cap domestic equities and 202 basis points for large cap at 100% annual turnover rates1.
Third, mutual fund expenses and fees are hidden inside the fund's reported daily net asset value computation. In other words, the fund shareholder never receives a bill from the fund company, nor is a fee ever deducted directly from his/her account. As with everything in life, when the cost is well obscured and structured so as to go unnoticed, it encourages the entity setting the cost to charge a higher fee than would otherwise be the case. A powerful example of this effect is seen most clearly with passive index mutual funds. Within the index arena, we are able to truly compare apples to apples, yet we find a tremendous range of hidden fees being charged for what is exactly the same portfolio. Sunshine is the best disinfectant. Separate accounts charge their fees directly to the client or directly to the client's account.
Fourth, mutual funds suffer from lower tax efficiency. The higher level of portfolio turnover resulting from their commingled structure causes capital gains to be realized sooner than would otherwise be the case. Moreover, a greater portion of their capital gains end up being characterized as "short-term" instead of "long-term." Finally, to make matters worse, federal tax law prohibits mutual funds from carrying capital loses forward in time (for eventual offset with future capital gains) beyond a very limited number of years. This last issue can be quite disadvantageous during an extended bear market environment. The 2000 tax year provides a telling example. As a result of the tech-wreck of 2000, many fund shareholders liquidated their holdings. This forced the mutual funds to sell out of positions in order to raise the cash required to meet the exiting fund shareholders. As a consequence, the funds realized capital gains, which they had to then transfer to fund shareholders. Unfortunately, those fund investors who had recently entered these funds ended up realizing a significant loss on their investment while at the same time being required to pay significant capital gains taxes on a gains that they never experienced. Separate accounts avoid each of these problems.
Fifth, mutual funds are driven by non-performance based objectives. Their primary motivation is to make money for the mutual fund company. They maximize such profits by maximizing their capacity and liquidity, having a hot marketing story, and never letting their performance fall too far behind the pack. These four objectives encourage them to over diversify (hold too many securities), maintain excess liquidity2, avoid those very attractive investment ideas that cannot be bought in great size, and attempt to track their performance benchmark so as to prevent lagging the pack. Each of these effects seriously undermines, if not prevents, outperformance.
Sixth, mutual funds are losing market share within the investment industry. At the passive end, ETFs and ETNs are grabbing market share. At the active management end, hedge funds are rapidly taking assets away from mutual funds. The mutual fund industry is experiencing a brain drain. Those fund portfolio managers that are most devoted to just plain simple performance-generating portfolio management are leaving mutual funds for the hedge fund world-and earning higher compensation in the process.
Each of these challenges can be successfully mitigated through the use of appropriately structured separate accounts. Separate accounts avoid the adverse consequences of commingling an investor's assets with those of others. Moreover, if structured correctly, they can overcome the non-performance based objectives problem faced by the vast majority of mutual funds. This last issue can be dealt with in the separate account manager contracting process and entails three ingredients. First, contractually require the separate account manager to ignore a passive index benchmark -- thus breaking the tracking problem. Second, contractually discourage them from building "balanced" portfolios that attempt to realize broad diversification across numerous industry sectors. Third, and most important, specify that instead of building a portfolio of 229 securities, as they would for a mutual fund, construct their portfolio from the 9 securities that they hold with the greatest level of personal conviction and forward-looking opportunity. Such a solution holds significant promise for overcoming the mutual fund underperformance problem. However, it requires the assemblage of a thoughtfully constructed roster of such "9-security" separate account managers, since each manager is unacceptable on a purely stand-alone basis. Conceptually, one can think of each "9-security" separate account manager as a single ingredient within a larger meal-unsatisfying by itself, but together with other food items, quite nourishing.
This approach is well supported by the latest academic research that has found a significant and quite robust ability of talented portfolio managers to add value-but one that is diluted away within the unfortunate mutual fund structure3 4. Wrap mutual fund has been disappointing. Fortunately, practical, economic, and prudent solutions exist-well grounded in academic empiricism.
Rob Brown, PhD, CFA, is chief financial strategist for Eqis Capital Management Inc. He can be reached at firstname.lastname@example.org.
1 "How Manager Style Influences Cost," May 1998; "The Official Icebergs of Transaction Costs," January 1998; "Costs by Market Cap: The Cost of International Liquidity," April 2000, The Plexus Group, http://www.plexusgroup.com/fs_research.html
2 "Investor flows and the assessed performance of open-end fund managers," Edelen, R., Journal of Financial Economics 53, 2002, 439-466
3 "Best Ideas," Randy Cohen, Christopher Polk, and Bernhard Silli, March 18, 2009, http://ssrn.com/abstract=1364827
4 "Information Acquisition and Under-diversification," Stijn Van Nieuwerburgh and Laura Veldkamp, NYU working paper, 2008