As it’s told, Albert Einstein had three rules that guided his work: One, out of clutter find simplicity; two, from discord, find harmony; and three, in the middle of difficulty lies opportunity. For a while I have become more and more frustrated with the financial industry, and in this paper I hope to provide a few points of clarity amidst the mess. While the street has learned how to sell “simple,” sadly simple in its profitable form is not always easy.

Many investors have been complaining loudly about the performance of their funds and the huge capital gains taxes that are tacked on by the IRS. Investors from the small retail client to the ultra-high-net-worth investor would like more transparency in their funds so they could find out what specific stocks that they are invested in. Most investors are feeling like they have lost control over the decision-making process regarding their investments at every level. I truly believe that there are better wealth-building opportunities that an investor can adopt to protect their assets and financial well-being.

In my opinion, the financial investment community, from mutual funds to hedge funds, has become bloated and lethargic. The majority of investors have been slowly losing their wealth for many years in mutual funds as well as hedge funds after 2008; fees and excessive costs are taking a toll in their pursuit to “beat the market.” During the bull market of the 1990s we saw plenty of double-digit returns, and there seemed to be a happy marriage between the investor and mutual funds. We see now at the beginning of the twenty-first century, there are red flags flying high and bright giving a warning to investors.

Mutual funds have a record of underperformance, hidden fees, higher income tax consequences, and a lack of investor control, and hedge funds aren’t far behind. Informed investors are now beginning to realize that they’re wasting their time and wealth in many of these “structured” products.

Don’t get me wrong, mutual funds did not start out as a bad investment. In fact, mutual funds have provided many Americans the opportunity to amass fortunes during their working life in their retirement accounts since the 1940s, when the Securities and Exchange Commission founded the Investment Company Act that created the concept of putting multiple stocks and/or bonds in separate funds. Since their invention, mutual funds have been good for Americans for many decades. Mutual funds were supposed to create an opportunity for the average middle-class American to invest like those with more substantial resources, and those with substantial resources were supposed to be able to use hedge funds to, well, hedge. These funds became the investor’s new best friend, offering professional management, many choices, and, for a long time, stress-free investing. It was truly a powerful force in the marketplace.

These pools of equities offered investors diversification and more safety than most individual securities at a price that was affordable. It was a shift from brand-name investing for the generations, where Mom and Dad would invest in one company like General Motors and hold for life, to broad-based baskets from the academic community.

This shift can really be attributed to Morningstar when in the ’90s it came out with its “style box.” This was a feeble attempt at simplifying something academic like the Capital Asset Pricing Model. Instantly people could “see” how a fund was “managed” in relation to other “styles.” Due to our inherent nature it was practically a dollar-printing shop for the industry, as it provided an easily understood graphic to articulate a vocabulary that was relatively nonexistent in describing client product demand. Yet as Eugene Fama and Kenneth French showed that bets on “style” frequently masquerade as skill and can attribute away many manager’s returns!¹

Soon mutual funds increased even more in popularity due to the government-offered retirement plan. We know these plans as our 401(k)s, 
SEPs, and IRAs. The fact is, today, over 40% of mutual fund assets come from these retirement plans. This sum is a major reason that vast sums of money were pumped into mutual funds. American investors finally had an affordable investment for the middle class family, but as the title of one famous book said, “where are all the customer yachts?”²

Times have changed. The mask is off and the real face of the industry is being exposed. If you read this full paper you will see what I am talking about. In the early years, funds were all about making money for clients, but now it seems that they’re focused only on gathering as many assets as they possibly can all while under the mandate of beating a “benchmark” rather than making money. Now they are sidestepping the spirit that was born in the 1940s, and it’s no different in the hedge fund industry, where A. W. Jones was to hedge the downside of his long portfolio. The industry is also optimizing as much market share as they can get even if they have to break a few laws to do it.

Let’s look at some statistical facts. In 1980, there were 500 mutual funds available to choose from with a total of $100 billion invested. As of June 2014, there are 8,300 mutual funds with a total of $26.8 trillion invested according to the Investment Company Institute. In 1990 the hedge fund industry only had $40 billion in assets under management, but now there are over 8,000 hedge funds managing more than $2.4 trillion.³ This is not a misprint; this monster keeps growing and growing. An investment pattern with this concept originally developed slowly.

Americans put about 20% of their discretionary wealth into mutual funds during the 1970s and 1980s. By the time the 1990s rolled around, investors were investing at a rate of 25%. In 1996, that rate rose to 60%. At the end of the century, the rate of investment in the mutual funds by Americans climbed to a staggering 82%! It’s not surprising that the firms that you see as “leaders” today were the early risers during the boom between 1980 and 2000.

Sadly this increase in the number of choices available has led to the inevitable expectation of better outcomes. As psychology has shown today, though, more (in the form of choice) equals less for us in the end. As Sheena Iyengar points out, satisfaction comes from the perception of control.⁴ But the desire for choice is not a choice in and of itself, even though the ability to choose well is one of our most powerful tools. Thus for most people, they are SELF-defeated before they even begin as they are overwhelmed by all their options with no means of process or TRUE measurement.

Before 2003, the worst thing we could say about a mutual fund was that most of them lost money and hedge funds were levered, scary instruments because of the lasting effects from Long-Term Capital Management. From 2003 onwards, we can now say something even worse about the group as a whole: a large number of mutual funds are now losing money fraudulently! In 2003, New York State Attorney General Eliot Spitzer crusaded ineffectively to put the brakes on the likes of major financial companies for improper trading of mutual fund shares. Blue-chip companies such as Bank of America, Strong Capital Management, and Bank One were implicated along with small-trader hedge fund Canary Capital Partners in schemes to milk investors of billions each year, according to Spitzer. Spitzer exposed more than 60 years of backsliding. In 2008 we had the largest Ponzi scheme in history exposed with regards to Bernie Madoff’s company. Of course just a few years later we have one of the strongest hedge fund performers with Steven Cohen and SAC Capital getting in trouble for insider trading! What this does as a result is leave people worrying about choosing the right options.

An industry entrusted with nearly $8.1 trillion of the American public’s money, mutual funds used to be the investment vehicles that investors relied on to finance the American dream of a home in the suburbs, good education for the kids, and a comfortable retirement.⁵ Hedge funds were supposed to be tools to help wealthy individuals protect themselves, not risk blowing up and losing their capital, and what is rule number one for a family office? Protect the principal.

Today we see that the nation’s 93 million mutual fund investors are basically overwhelmed by the competing claims of some 8,000+ mutual funds. Just look at the two powerhouses in the industry: Vanguard and Fidelity. Each of them has a different core message. Vanguard believes in low cost and that beating the market is stupid, so being cost focused is key. At the same time Fidelity is focused on its ability to distribute its “stars.” These two names became masters at selling their unique selling points.

Most of the time investors are clueless about how to enhance their wealth using mutual funds. The average equity fund lost 12% during the year 2000, 2001, and 2002. Since that time the results have not been much better. In fact if we look at the last 10 years of the general market, which most mutual funds and even hedge funds track, we can see an eerie indication about the weakness of their viability to grow your assets in a stable manner in relation to purchasing power.

We can see in this chart that the compound annual growth rate has actually been negative! The fact that economists even mention the term “wealth effect” should tell you something! This measure of return in relation to the purchasing power is shockingly bad. It’s not the stars nor is it the cost, it’s the manager’s process that one invests in, not some little box. As Warren Buffett has said, “If in a game of poker you don’t know who the patsy is, you’re the patsy.” I give no ill face toward Fidelity or Vanguard, as they did their job: Make money for the company. The responsibility lies on the investor’s shoulders. It’s a sad day when people spend more time choosing their next refrigerator than their investments. For people across the gamut, from mutual fund to hedge fund investor, I recommend a paper by Andrew Weisman called, “Informationless Investing and Hedge Fund Performance Bias.”⁶ It does a great job of describing the fallacy of using the Sharpe ratio as a measure of goodness, especially for hedge funds. As Ronald Reagan used to say, “Trust but verify,” and in our opinion you need to be verifying with at least the right tools.

But that’s just about return and doesn’t include the hidden killer, either. Let’s get to the real problem in this industry: fees in relation to risk. It is the expenses that kill returns. Average investors are so confused by these expenses that they have no idea what they’re paying, and high net worth investors are willing to accept unfair deals. The sales commissions for the most active managed funds are tacked on by the brokers and are usually around 6%. The fund deducts at least half a percentage point on average from your account for its service. Cash drag, a reserve set aside for opportunity cost or to pay off redemptions, will add another 0.6%. Rich people with hedge funds aren’t out of the woods, either; don’t forget about funds of funds. A third of hedge fund investors use these outsourced instruments and they have their own added costs wrappers as well. A question I constantly ask people is that it’s not how much are you paying for your return, but how much are you paying for your drawdown?

The point is that investors pay billions in costs and fees per year. What do they get in return? They almost always receive mediocre performance and yet all the risk when you factor in taxes, and many actually suffer a financial loss. A stable bond fund, real estate, individual stock, or even a treasury bill may perform as well as the average mutual fund trading equities. Sadly, over the last few years, this is even true for most hedge funds as well. More and more when one digs under the hood, one just discovers “closet indexers”—those just trying to match an index and not wanting to stray too far from it “in case” they are wrong and their performance lags the benchmark index. What does Jones say? “Losers average losers.”

The churn (turnover) of stocks that fund managers perform all year long causes these transaction costs. In fact, the average turnover of the stock is 80% or higher yearly for nearly every stock and mutual fund portfolio.⁷ By conservative estimates, this wraps up an expense of 0.7%, not including capital gains tax, which also eats away at your profits. On top of this, add another 1.5% for management fees and expenses including the dreaded 12b-1 that those outside the industry strongly criticize. You better believe that those inside the industry continue to exploit it for all that they are worth! In a hedge fund, the transaction costs are socialized due to being commingled vehicles. This makes it very hard to measure costs in relation to net asset value.

Let’s take an example. Assume your fund is generating a good return in today’s market with an assumption of 12% compound annual growth rate of total assets (as a long-term buy-and-hold investor). The commissions, costs, cash drag, and fees reduce this to 8.7%. In short, the cost of your fund manager is close to 3.3%. Therefore, the fund is underperforming the market by at least 3.3%. After taxes, which I estimate conservatively to be around 0.7%, you will have no more than 8% of the original 12% return. This is only two-thirds of your fund’s return that you get to take home and put in your pocket, but in reality it is probably much less than this. Now this type of performance isn’t bad and should be paid up for IF the manager is able to manage risk and thus the drawdown is less than the market’s risk in relation to the generated return. Sadly, as history has shown, the bottom line is that mutual funds cost way too much in relation to their return to the risk taken, and hedge funds aren’t doing their mandate—hedging—either.

The typical investor is averaging 3.5% in cost. What always shocks me is that most people balk at the typical 2/20 structure with hedge funds, and yet if we assume an average return of 12% for the hedge fund, the total cost comes out to only 4.4%; that’s less than one point greater than the cost of a supposed “fee friendly” fund. A lot of people will ask, “Well, where’s the value?” To that I say, simple, let’s take a look at the market’s MAR ratio (remember the one from before?) to the fund’s MAR ratio. As we have seen in our chart, the market’s MAR ratio is around 0.1—well, at Hawking, for us, an acceptable MAR ratio is 0.5. That means that we provide a 400 times value for only a 1% increase in cost! At least with a hedge fund they don’t get paid their 20% unless they MAKE the investor money. The reason that you see conflicting fee charges for mutual funds is that there are multiple fee revenue streams and many fees that are charged, but are hidden to you.

Sadly, we can look at mutual funds as a billing iceberg. Most of an iceberg is unseen, underwater. Mutual fund companies have become increasingly adept at applying extra hidden revenue streams to their funds, in addition to the standard fees, which are also going up over time. In fact, as returns have diminished during the post-2000 
era, mutual fund companies have actually been raising fees. The average mutual fund investor isn’t even aware of the fees he is paying, disclosed or undisclosed. In fact, shareholders are paying for mutual fund advertising and promotions through 12b-1 fees. At least hedgies have to pay for their marketing out of their own cash flow. Unfortunately, as mentioned earlier, most investors don’t read their mutual fund prospectus, where a lot of essential fee information can be found. All 93 million mutual fund investors reward mutual fund companies annually with about $70 billion in operating cost—and most investors don’t realize they’re paying it.⁸

What is investing in funds really costing you? You can expect to pay approximately 3% to 4% of your fund assets yearly in total cost (upfront or backend cost) for a load fund. For no-load fund, you’ll still be paying around 3% to 3.5% for your portfolio mutual funds. If you do some serious checking into these costs over the life of your portfolio, you’ll see some serious money going into the coffers of the mutual fund companies over and over again.

Unlike paying your gas bill or your electricity bill regularly, you’ll hardly ever receive a bill from your mutual fund company. Your costs are simply deducted from your portfolio returns right off the top when the broker executes a trade. You may scream if your daughter makes an unauthorized credit card purchase, but where are you when you pay a 5% load on a $25,000 mutual fund investment? With the boom of mutual fund returns in the 1990s, wouldn’t you think the fund companies with these huge infusions of cash coming in and internal expenses going down would reduce fees for their shareholders? Don’t count on it. The resulting discovery of this has seen the rise of low-cost funds or ETF’s and the use of research to expound upon the virtues of “passive” investing. How “riding it out” is a sound strategy. Since when did passive anything work in your life? You got here by your sweat and hard work. In fact, just a little elbow grease can go a long way. The problem is that “passive” is not a USP, it’s a solution to fees, and the truth is it’s turned into preying on the fear of investors of “missing out.” As a wise manager once told me, just because exposure is there, doesn’t mean you need it.

In fact, due to the fixed cost of fund companies (staffing, accounting, research, and so forth) becoming smaller (thank you, technology), fees actually could have been reduced, much like trading costs were squeezed by low-cost brokers. Remember, fund companies increased revenues many times when AUM went in the year 2000 from 371 billion in 1984.⁹ John Bogle says “the drive to make money for others—the fund’s ­shareholders—may not be as powerful as the drive to make money for oneself through ownership participation in the management company. There are two sides pulling against each other in mutual fund companies: the shareholders (the investors in the mutual funds) and the stockholders (the investors in the mutual fund company).”¹⁰ For the hedge fund industry and its structure, an important question to be asking your manager is what they are looking for in a strategic partner, as most funds are in the form of a partnership, aren’t they? When dealing with someone’s money, from $100 to $1 billion, a form of partnership is entrusted and should be viewed and PROTECTED as such. There shouldn’t be a pulling of conflicting goals, there should be an alignment of them. When everyone is aligned together, everyone is most likely to come out ahead. This establishes the most critical element, which is trust. One way to confirm that is by making sure that managers invest in their own funds or at least that the performance structure in place aligns the manager with the investor not against them.

“Investors today are being fed lies and distortions, and are being exploited and neglected,” says Arthur Levitt, former chairman of the SEC. “In the wake of the last decade’s rush to invest by millions of households, and Wall Street’s obsession with short-term performance, a culture of gamesmanship has grown amongst corporate management, financial analysts, brokers, and mutual fund managers, making it hard to tell financial fantasy from reality, and salesmanship from honest advice.” A study by Dreman and Berry showed that there was a significant gap between Wall Street analyst’s estimates and actual corporate profits.¹¹ What was more striking was that they found that this gap is increasing as time AND TECHNOLOGY go on and becomes more sophisticated. Sadly, we live in an era where a manager touts his AUM and not his risk-adjusted return.

Did you know that around 15 years ago there was not one TV channel that covered detail market news? Today there are, according to ­Robert B. Jorgensen¹²:

• Hundreds of radio stations that report financial news
• Specialized financial newspapers and magazines
• Three major cable channels that are devoted to financial news
• Most major and minor newspapers have business pages
• Thousands of newsletters that cover financial topics
• Hundreds of thousands of websites that pertains to financial ­investments
• Financial salespeople to make calls
• Advertisers, slick brochures, and mailing pieces abound with financial offers

Literally hundreds of websites are positioned to reveal the latest hot investment opportunity for investors at every level; those worth thousands to those worth millions to hundreds of millions. All these triggering devices want you to believe they’re rubbing the lamp with one rub that will propel you to untold riches with, as most look for, no hassle and no requirement to understand the investment. But, as psychology experts have shown, the more we use “experts” the higher we set our expectations, without any quality metric and the larger the potential for 
disappointment.

It’s time for you to come to the truth about the industry and not just accept it for the “norm” or you will suffer the consequences:

• The tax consequence—If fund managers sell stock at a profit, you take a capital gains hit even if your fund lost money.
• The quick change consequence—You invest in the fund to fulfill a certain investment strategy. Be careful; the manager can change the strategy.
• The no-diversification consequence—Unless you’re diversified across fund sectors, you may wind up owning the same stock in different funds.
• The name’s the game consequence—A stock fund’s name doesn’t always reflect its investing intentions.
• The moving manager consequence—Managers come and go. If you lose your manager, your account will probably suffer, if the team isn’t being built to take over the roles of leadership at every level of 
management.
• The huge-fund consequence—The more assets a fund takes in, the higher the chances of lower performance.
• The fee consequence—You’ll pay myriad fees and commissions.

The bottom line is that most fund management companies fall short in regard to performance and returns with investors’ stock funds. At the same time they are a master at sneaking in fees and add-on charges. In short, most funds are a marketing success, not an investing success, and ride the coattails of those that do perform, and why would those that perform care? It’s their edge for outperformance!

Former SEC chairman Arthur Levitt says, “Investors simply do not get what they pay for when they buy into a mutual fund; most investors don’t even know what they’re paying for. The industry has often misled investors into buying funds on the basis of past performance. Fees, along with the effect of annual expenses, sales loads, and trading costs, are hidden. Fund directors as a whole exercise scant oversight over management. The cumulative effect of this has manifested itself in the form of late trading, market timing, insider trading, and other instances of preferential treatment that cut at the very heart of investor trust. It would be hard not to conclude that the way funds are sold and managed reveals a culture that thrives on hype, promotes short-term trading, and withholds important information.”

Results come from having a method to the madness, not a checklist or box. Investment satisfaction doesn’t come from great performance, and truthfully would be okay with all the fees and costs IF expectations are fulfilled. That’s why I have talked about trust, because trust is the foundation of confidence, and that should be the objective of the Street; to instill confidence once again by setting the right expectations.

What does this mean to you as an investor of your hard-earned money into mutual funds and hedge funds? You’ve entrusted your money and your wealth to these managers, but you’re getting the short end of the stick when it comes to them doing their number one job of managing risk first. This is surprising because we’ve always been told that the stock market is the single best place to build wealth for your families and your retirement. This is true if you’re getting the most value for your dollar from managers that concentrate on risk-adjusted returns. If you’re not, your portfolio is on a hamster wheel going nowhere along with the assets of millions of other dejected mutual fund and hedge fund investors. My purpose here is to get you off of the wheel, and I hope by this point I at least got you starting to think outside of just return, and at least realizing that you can’t do what everyone else is doing and get “outperformance.”

So how can something go so wrong? In 2013, mutual fund assets totaled over $13 trillion.¹³ This increase can only naturally call for companies’ priorities to shift. It’s evident that the mutual fund industry does not hold the individual investor in the highest regard and the hedge fund industry is not far behind. John Bogle, an outspoken critic of mutual funds and the founder of Vanguard Financial, says his biggest complaint of the mutual fund industry is that it’s now run like a business where cash flow from asset fees rather than return is the priority. Bogle traces the industry’s demise to a 1956 federal court ruling allowing mutual fund firms to become public enterprises. This changed the playing field, according to Bogle. “That opened the door to look at this business as an entrepreneurial business in which the focus was on making money for the stockholders,” he said. “Once you change the investment profession into a marketing service business, you put management in the backseat and marketing in front.”

People have been waking up to this, as the mass exodus in 2008 showed, and the lack of volume back in the markets in the subsequent years. This doesn’t mean that mutual funds and the companies that produce and market them are going to become extinct. In fact the opposite is true. At the time of this writing, mutual fund companies are evolving. They’re developing new alternatives and investment strategies like low-cost ETFs and replication structures in order to hold on to their client base and secure new clients. Eventually, though, mutual funds will take a backseat to new forms of investing for the emerging affluent investors. Brian Portnoy said it best, “‘Convergence’ is upon us.¹⁴ The once-distinct traditional and alternative investment worlds are colliding rapidly. Traditional asset-management firms, fighting shrinking margins on their core business, are building new forms of investment risk that can be packaged and sold at premium margins. Meanwhile, hedge fund shops, generally tiny in comparison, see massive yet untouched markets that can be potentially accessed by delivering more investor friendly structures. Alternatives are going mainstream, and fast!”

Mutual funds are dying in their original state because of the unfairness of fees, unnecessary taxes, lack of investor control, and a host of other reasons. Don’t think hedge funds are any different, though, as the industry has seen its fees shrink from the normally 2% down to an average of 1.5%. Investors have never grasped these points until now. Today, a lot of investors understand the drawbacks of mutual funds because the events of the last five years have brought the message home. They discovered that they’re paying out millions of dollars in excessive cost in running needless risk, all in the hope of outperforming the market based on return without even properly considering risk.

We need government to rise to the occasion, but know it won’t, even as the government examines more critically the operating policies of mutual funds; things will only slowly change. Increased federal and state scrutiny will trigger more reforms that will probably get the ball rolling in Congress, like the Mutual Funds Integrity and Fee Transparency Act that the mutual fund industry successfully lobbied against.

Meanwhile, underperformance is the norm for mutual funds and 95% of most hedge fund managers. In recent years, the mutual fund companies could perhaps be forgiven for the huge marketing expenses and increased salaries of their star managers if the product delivered as advertised. But this is no longer the case. Underperformance is the norm rather than the exception. It’s a fact. In spite of our respectable pass during the 1980s and 1990s, the average mutual fund returned 2% less than the returns of the market each and every year while still participating fully in the downside moves.¹⁵ Sharpe, Treynor, and Jensen showed that a sample of mutual funds from the ’40s to the ’60s could not outperform buy and hold, nor even a randomly generated portfolio!¹⁶ It’s not just the mutual fund industry, though. One study found that only 21.2% of fund of funds managers find alpha after fees, and only 5.6% of them add value above the alpha from what they are investing in! At the very least one should be asking for a manager’s aggregate profit and loss to see if his constituents have actually made any money.

“In the mutual fund industry, we used to be in the business of long-term investing; now we’re in the business of short-term speculation” said Bogle. Not only do the fund managers tend to underperform the S&P 500 yearly, but the underperformance also has grown more pronounced over the years. The individual managers responsible for funds are now marketed as stars. The truth is that most market outperformance lies in the hedge fund industry and even in that niche only a few dozen like George Soros, John Paulson, David Harding, Jerry Parker, Bruce Kovner, David Tepper, and Louis Bacon have made their clients money. More staggering is that these few have also produced most of the return for the whole industry! Even more surprising is that only 7% of funds that are better than the sixteenth percentile manage to repeat that performance every year of their life. This means that attempting to pick THE best fund to ALWAYS outperform is futile, as there’s no evidence to support that it is possible. However, finding managers for a particular objective can be done. As Brian Portnoy points out, it revolves around trust, risk, skill, and fit.¹⁷

Investors and potential investors are subject to the billions of dollars of advertising promoting the virtue of funds and mutual fund managers who are supposedly skilled in handling their money. With the new JOBS ACT, don’t expect this to be any different in the future, as hedge funds get into the marketing game more and more. The chances of the fund manager beating the market are small, so small that the average mutual fund only outperforms the market two times out of every five, according to mutual fund researchers. If you’re still not convinced, consider this¹⁸:

• Through the end of 2001, there were 1,226 actively managed stock funds with a five-year record. Their average annualized performance trailed the S&P index by 1.9% per year (8.8% for the funds and 10.7% for the index).
• Through the end of 2001, there were 623 active managed stock funds with a 10-year record. Their average annualized performance trailed the S&P 500 by 1.7% per year (11.2% for the funds and 12.9% for the index).
• The figures above include the sales loads charged by many funds. Loads are akin to brokerage commissions, which come straight out of your returns. They are charged when you buy or sell shares of your fund. Even with these load funds excluded, the five-year average trailed the S&P 500 by 1.4% per year, and the 10-year average return trailed by 1.4% as well.
• These figures didn’t include discarded mutual funds, which would reflect poor performance and bring these averages down significantly. The exclusion of these mutual funds is called “survivorship bias.” With returns corrected for survivorship bias, average actively managed funds trailed the market by about 3% per year. This self-selection bias isn’t just inherent in the mutual industry but shows up in the hedge fund world as well, as Dichev in 2009 was able to show.¹⁹ The reason being is that as a fund dies off the last few months of underperformance never get reported and thus logged. The estimates of this effect on true return for these indexes ranges from about 3% to 5%.

Cost will drag down your performance. Fund managers are supposed to be good, and some of them certainly are, except we don’t know which ones are good until the returns come in. Most managers, unfortunately, will only equal the market as a whole before costs. As famous fund manager Paul Tudor Jones said, “Losers average losers.” What drags performance down is the management fees, trading costs, sales loads, and other incidentals. And thus, direct and indirect costs defeat the performance of most funds before you get your feet wet.

Mutual funds must disclose that past performance is not indicative of future results. Unfortunately, most investors and financial media use past performance as their primary selection criteria. I once sat in a room with a major institutional allocator who got on the phone to say, “The only thing that’s indicative of the future for me is past results.” I was shocked as these guys were supposed to have some type of system for this kind of thing, but sadly this is what most people can only use as a means to measure “good” without proper education of what “good” is.

The truth is, most mutual funds rarely outperform the markets for a significant period of time. Only eight funds in the history of mutual funds have outperformed the S&P 500 for more than 10 years straight!²⁰

Next let’s take a look at taxes associated with mutual funds. There are no tax advantages to mutual funds, only disadvantages. If you pay taxes in all mutual funds, you have created a natural adversarial relationship. You’ll probably have to pay taxes when your stocks are sold in the portfolio. Not only that, you may also have to pay taxes when your stock fund loses money. Mutual fund companies during the tax year are required to distribute capital gains and the dividends to their shareholders. Unless you own a non-taxable mutual fund (i.e., municipal bond fund, retirement account, etc.), you probably are going to have capital gains.

Mutual fund companies are not looking out for you when it comes to taxes. Shareholders pay capital gains taxes; mutual fund companies don’t. In 2013 your capital gains are taxed at the standard tax rate: 28% to 36%, depending on your reported income, for stocks held less than one year.²¹ If you hold funds for more than a year, it’s 15% across the board.

Statistics show that American households paid $345 billion in capital gains taxes on mutual funds in the year 2000.²² These gains have accumulated throughout the 1990s. When the air came out of technology stocks, portfolio managers began dumping them. But even if the stocks have lost their original value, they still accumulated capital gains. Remember, even if your stock fund loses money, you’re still liable for capital gains because during the fund’s history it made money, making its capital gains embedded. I haven’t even mentioned dividends. Even if you reinvest your dividends back into the fund, the IRS says you’re still subject to tax on your dividends.²³

There are ways to cut your tax bill with mutual funds if the companies were responsible. Critics charge that fund companies could lower their capital gains distributions if they wished. One way is through improved bookkeeping. If the fund companies were programmed to sell their highest-cost years first once they reduce the large block of stock, it could result in the tax savings for the investors. This is called HIFO (highest in, first out) accounting, according to Vanguard, the low-cost index fund company, because it could save investors as much as 1% of assets each year due to lower cost. Trading this often would hinder the capital gains explosion, but because the average mutual fund turns over its stocks once in the course of a year (on which the commission is on average five cents a share every time a share is traded), this seems unlikely.

The mutual fund structure prevents “tax harvesting,” the timing of securities by its manager to utilize capital losses or defer capital gains. Regardless of when you buy into a mutual fund, you become the proud owner of the liabilities that were incurred before you even put your money down. So you buy into a fund for $10,000 on December 12 at $10 a share.

Shortly before the year ends, your mutual fund company calculates a yearly capital gain of two dollars a share. Guess what? Because you have 1,000 shares, you will shortly receive the distribution of $2,000, all taxable to you. Even though you’ve only been in the fund for a couple weeks, you will have to pay the same amount of taxes as the fellow that had been in it all year. Your original $10,000 investment may still be intact, but now you have a $2,000 tax bill. That’s why you should never buy into a fund in December when mutual fund companies record the year’s performance (my full opinion is that you should never buy a mutual fund, period). Yet a focus on taxes is really just a moot point that sidetracks one from thinking in risk-adjusted terms.

Always examine funds by their after-tax returns, rather than pre-tax. Even then you still have things like basis risk and gross exposure (don’t just look at net) which tilts analysis into the realm of the complicated. You won’t find these figures in the fund advertisement or the colorful brochures. You can find these figures in the fund’s prospectus, in very small print. Thanks to the SEC’s February 2003 ruling requiring mutual fund companies to include pre-tax and post-tax information in their prospectus, companies cannot conceal this information.²⁴ The only problem is that most investors don’t read the prospectus. For example, a lot of investors who bought into a popular fund that year saw the capital gains were spread amongst a lot of people. A bear market emerged because many investors rushed to liquidate that particular fund and its manager had no choice but to sell as many stocks as possible to raise enough capital for those redemptions. A huge capital distribution was left for the remaining stockholders. There are examples of investors who put a few thousand dollars into a fund and later were hit by Uncle Sam for a five-figure tax bite.

Was there a chance that the mutual fund managers could have foreseen the taxpayer’s dilemma and altered their selling strategy? Not a chance. Mutual fund managers are not paid to maximize tax efficiency, only to generate returns, and I wouldn’t want it any other way considering how big our tax code is. Which means that they need to concentrate on incentive-aligned structures. Once you’ve identified those structures then it’s all about looking at how the manager aligns himself in what Brian Portnoy distinguished as the five keys: concentration, leverage, directionality, illiquidity, and complexity.²⁵ The “perfection” of what you are trying to look for is whether the manager is diversified (by systems too?), market neutral, unlevered, highly liquid, and simply executed.

The mutual fund industry profits by keeping the spotlight off such issues mentioned above. As long as the fund companies keep you ignorant, the negative elements of mutual funds won’t ever be brought to light. Most investors traditionally have to make do with minimum information. That’s the bare minimum ruled by the SEC. Twice a year, you get to see what’s going on in your account. Investors said they want their financial information 24 /7. Even though the Internet has sped up the tracking of investments considerably, major fund companies have been painfully slow to keep investors current. This means that when you check your holdings on the Web, your figures are out of date, and possibly flat-out wrong or altogether missing because fund managers are changing your portfolio so rapidly. This is why we utilize our own proprietary risk management software that runs and monitors every position in every portfolio by our stringent risk controls. Each of these is compiled in a risk report that allows us to make sure that our return drivers are not evincing false diversification by having the same underlying risk even if we are perfectly hedged long and short with excellent returns.

This is why communication between investor and manager is paramount. With our clients we are able to give them access to their own portfolio, and they see their own risk all the way from a trade-by-trade level to portfolio level within our own front end we call positive alpha. This allows us to engage in a conversation that each party must have with regards to answering the question, what do you do and are you the right fit for me? As an aside, this has little to do with return as the basis for the relationship, and that is because that is the manager’s job (or at least should be), and since we have shown that performance chasing doesn’t work, then each party, manager and investor alike, must be able to answer the question, what is MY personal objective in the context of the risk being taken?

We must never underestimate the rich man’s appeal of mutual funds. Many older and wealthier Americans in this country own mutual funds and are comfortable with the investment process that has been around for some 60 years. That feeling is disappearing. Today’s investors are more comfortable with change. Today, those with emerging affluence are asking themselves if they should stay with the ultimate retail ­investment—one that is associated with mass-market investing and that is now viewed by many as a commodity. Mutual fund managers don’t differentiate between one investor and another. Their job is to boost the inflow from the account and to get the numbers regardless of who’s investing in the fund. The bottom line is mutual funds do not treat their investors like the good old days.

Unless you are totally shut out from the world, you have, like most of us, regular contact with people. Family and friends are a given. You like human contact and feel goodwill towards people most of the time. This leads to the inevitable interaction of crowds. The downside of human contact is when you find yourself in the overstuffed elevator and get stuck between floors. It’s uncomfortable, stressful, intimidating, and even scary. The same can be said of mutual funds. You’ll have crowded elevator contact but you still have contact with people.

Dealing with other investors in your mutual fund can invoke feelings similar to the overcrowded elevator—stress and intimidation. The inflows and outflows caused by human nature may be some of the more subtle difficulties of mutual funds. Fellow investors panic when the markets fall and become greedy as the markets rise. Instead of following the traditional words of investor wisdom—buy low and sell high—just the opposite occurs with disastrous effects for everybody.

Every investor feels the impact of a bloated fund with too much cash. It becomes too unwieldy for good management control. This causes funds to grow too quickly, turning good-performing funds into bad performers from one year to the next. In one important study done on long-only managers, it was found that the trading in and out of funds by pension plans, the “pickers” would’ve been better off sticking with their original choice.²⁶ This is a classic example of gambler’s fallacy, where we are constantly trying to find patterns and “reasons” where none exist. Two books I highly recommend all people read are The Invisible Gorilla and Fooled by Randomness.²⁷ Each of these books discusses the dangers of how our mind operates and “sees” things and the many errors that plague everyone from the genius to the working man.

The better question is why attempt to “game” a system that doesn’t seem to work to begin with?

“One advantage of mutual funds that’s really a disadvantage is it’s easy to get out of them,” remarked Peter F. Tedstrom, of Brown and Tedstrom, Inc. “This makes it simple for an investor to call in an order as soon as the market dips,” said Tedstrom. “Consequently, in the end, the investor suffers poor performance returns by frequently trading in and out of his or her portfolio.” This is on top of the fact that we’ve already shown managers have very high churn ratios in and of themselves! This effect is apparent in hedge funds too, as 2008 showed when funds of funds were pulling their capital out of hedge funds and the result of such large client redemptions was an effect on return as well. Even a legendary investor with one of the longest track records, Paul Tudor Jones, had to put a restriction on withdrawals from clients so as not to adversely affect results.²⁸ That was how much the madness had crept into all aspects of the financial industry. This very story above shows that even the world’s elite, as investors in hedge funds, are momentum investors, trying to chase performance.

One thing I constantly harp on about to people is that hedge funds and mutual funds are NOT asset classes and people have to get that into their head. Stocks and investing are an ALTERNATIVE to excess cash that one has. This is a problem much of the world doesn’t even have! The point is that investing in liquid assets is for an alternative to cash. People will always want access to their hard earned greenbacks as quickly as possible when things FEEL the slightest bit bad. As I tell people all the time, humans think linearly but react emotionally and don’t think that there isn’t emotion tied with money. This ease, portrayed as an advantage, is really a disadvantage due to its effect on our decision making and must be taken into account. As an old trader on the floor once told me, “It’s always easy to get in, it’s never really as easy to get out.”

It’s time to start asking the tough questions no matter the fund, style, or manager name.

What is the market risk, the liquidity risk, operational risk, is there any style drift? All of these things as well as the core we mentioned above need to be carefully considered. I personally am a fan of Portnoy, in his book The Investor’s Paradox,²⁹ where he mentions the 5 P’s: portfolio, people, process, performance, and price. As he says, it’s all about method over storytelling (something this industry is fond of). What one needs to be focusing on is finding someone with a repeatable coherent process. There’s more to proper choice than just fees and pedigree, as Vanguard and Fidelity have shown us, as well as checking off style boxes and number of allocations.

It’s time for action and to ask the tough questions of why have results for clients been so poor. What kind of transparency should I get? What kind of fee structure aligns me with my manager’s goals?

Is this the end of investment bank and brokerage domination? I don’t think so. You must understand that mutual funds are an American icon. Since the first mutual fund was formed, it has been the building block of our country’s investment strategy and home to some 93 million Americans today. Habits die hard, even in the face of the facts given above. My guess is that only half of the readers take any significant action.

Let’s face it; millions of Americans will continue to put their hard-earned wealth into the mutual fund vehicle seeking magic returns, and wealthy people will continue to chase protection in hedge funds. They don’t get the message. Did your parents ever ask you, “If everyone else jumps off a bridge, are you going to do it also?” Just because most people are too lazy to do their homework does not mean you have to be. We now have better options out there for one to accumulate future wealth. Ultimately an alignment of goals and skill at meeting expectations is what brings fruitful results. With hedged solutions beginning to be offered in 401(k)s, people are beginning to ask the right questions. But each person must come to their own conclusion regarding a manager’s integrity, stability, and investment process.

As you go down the road of looking for the best risk-adjusted returns, remember the old saying, “You can’t eat a Sharpe ratio.” Look for those that have the ability to robustly adapt and not just data-mine within the context of their edge. Align yourself with the manager that is able to deliver consistent risk exposure for you, and since one can’t have return without risk, you are going to want to see a process for effectively handling risk.

You can leave a legacy and you can break the chains of bondage that hold a lot of investors down. It must always be remembered that growth is not a given. We could very well be in a unique episode of human experience these past 200 years. The world and its returns from the past are no longer here today and the unique social and economic drivers are not here to support them anymore. To look at return without also looking at downside risk is a dangerous bet that I am not willing to make.

Smart people are looking to merely answer the questions of what can go wrong and what are the results if that occurs.