Bryan Binkholder Discusses How Bond Managers Hide Risk Factors…& Other Lies
Society often runs on the “What they don’t know won’t hurt them,” system of thought, especially when it comes to making money in the financial industry. Marketing and advertisements are geared to tug on the ‘pleasure seeking’ part of our psyche. We all want to retire and live a carefree life of boating, golfing, and the ability to fill our agendas completely on our own terms. According to many mutual fund managers, the path to this picture perfect lifestyle is paved with the purchase of their exclusive, A-list, and practically risk-free preferred funds.
Unfortunately, behind the shiny exterior (insert the vision of a flashy, impressive Power Point presentation set to motivational music here) of every ‘sure thing’ is a list of facts that are downplayed (or sometimes downright stuffed out of sight). Today we want to look at how bond managers hide their funds true risk.
Average Credit Quality
Managers of bond mutual funds often use “average credit quality” statistics in their marketing materials. This figure is based on individual bond ratings from Moody’s and Standard & Poor’s. Unfortunately, these figures are nothing more than a smoke screen. In case you weren’t aware, portfolio managers can easily manipulate their holdings to considerably raise their credit risk (to increase their yield) without affecting the reported credit risk at all. How convenient for them.
This tactic is particularly dangerous because mutual fund managers compete based on yield and risk, which makes “gaming the system” and causing you to take more credit risk than you may be aware of especially tempting.
There are a variety of ways fund managers do this. For example, most funds have a cutoff point where all funds which are at or below a certain rating are all counted the same. Sound crazy? Of course it does. If a fund with a BB rating is the cutoff point, that would mean the lowest possible grade (CCC/C) would be rated the same as the BB, even though it would have well over five times the credit risk.
Another trick is the fact that some funds simply don’t include unrated bonds in the calculation of average credit quality. So, this would basically mean that to them, the word “average” means nothing more than a number they come up with, –one way or another.
Not only should past performance not be a determining factor, since past performance does not guarantee future returns (not exactly a new concept), but mutual fund managers use extremely skewed information when it comes to performance.
That’s another story. Right now the largest bear market, which ended in early March of 2009, is sliding off three-year performance records. Dropping this ‘biggest loser’ can do wonders for a fund’s record and also makes for exciting marketing materials and adrenalin fueled presentations from mutual fund managers. No matter that it doesn’t paint a true picture of actual performance. That’s a minor detail. The average stock fund gained over 50% the past three years. Just one year ago, that same picture (three-year performance figures) would have shown a 4.7% loss. I doubt if mutual fund companies were capitalizing on that figure, but a 50% gain? Now that’s something that will take eager new investors straight to the, “Where do I sign?” paperwork.
Fund managers are using these “selected time periods” to tout their skills, assuring clients that they have what it takes to continue to bring earning percentages like this in the future. Never mind those pesky disclosures that state otherwise. Just keep focusing on the presentation.
Here’s a couple of companies who are feeling the difference a year can make.
Fidelity Contrafund which was down 5.1% the three years ending 2010, was up 50% for the past three years.
Dodge & Cox Stock was up by 43% for the past three years but their track record for the three years ending in 2010 has them down by 15%.
American Funds Growth Fund of America was down 8% for the three years ending with 2010, but up 44% for the past three years.
And it All Boils Down to…
The two popular tactics outlined above should only serve to solidify the one main, underlying point, which is pretty simple. Mutual fund companies have a product. This product (selling funds) makes them a lot of money. Subsequently, these fund companies are going to put their best foot forward. If they don’t have a “best foot” they will invent one, out of thin air if they have to.
- They will cleverly lie with statistics.
- They will encourage the ‘chasing performance’ game, even though we all know this behavior is unwise.
- They will use benchmarking in ways that clearly do not compare apples to apples and come up with misleading conclusions.
- They will use 4 and 5 star ratings (given by Morningstar) to decide which funds to buy and which to withdraw money from, despite the fact that Morningstar itself admits these ratings mean nothing. They are not predictive and the higher rated funds aren’t guaranteed (or even likely) to outperform 1-2 star rated funds.
In the words of David Swensen, ” The fund industry costs investors billions in lost returns every year — while coining money for itself, its employees, and its distributors.”
No one can predict the future, therefore, self proclaimed gurus are nothing more than smooth talkers peddling their questionable and contrived statistics. The only way you’ll actually see significant returns is by cutting out what you CAN control, –and that is cost.
The lower the cost of a fund, the more likely it is to perform well. This is just one of the reasons why actively managed funds are a losers bet. Your manager’s salary is taken right of the top and most returns aren’t significant enough to offset the hefty costs involved.
Why don’t financial advisors tell their client’s these simple truths? I have a one word answer for that: Commission. The bonuses, commissions, perks and fees they receive from selling you on actively managed mutual funds cause a clear conflict of interest. The loyalty and trust, which should be between advisor and client, is simply not there. Instead, all loyalty and obligation is from advisor to mutual fund company.
Are you catching on to the game yet? To learn more about investing, and how to avoid the traps and pitfalls, I invite you to take advantage of the free resources available on The Financial Coach Show website. The good people at Blue Ocean Portfolios (who do not receive commissions, bonuses, or perks) are also available to answer your questions. If you think you’re being taken advantage of or even have the slightest wonder, please don’t hesitate to contact us. We’ll tell you what to look for, what questions to ask, and help you determine whether your financial advisor is truly operating in your best interest or not.
There’s no time like now to set your financial future straight.