The Investment Scientist

“Good intentions” doesn’t cut it

Posted on: January 25, 2010

Guest author: Mike Piper

There are inherent conflicts of interests between for-profit mutual fund companies and the investors in funds run by such companies. For example:

  • Investors benefit from low expense ratios. Fund management benefits from high expense ratios.
  • Investors benefit from plain-English, thorough disclosures regarding costs and conflicts of interests. Fund management benefits from poor disclosures.

A reader (we’ll call her Martha) recently asked me if such problems could be avoided by using mutual fund managers who have the interests of their investors at heart.

Specifically, Martha happens to be personally acquainted with a particular fund manager. She’s read this fund manager’s investment newsletter and blog for several months, and she’s exchanged a few emails with the manager. Martha also knows that this fund manager is a deeply religious person, whose faith closely matches her own.

Those all seem to be favorable indicators.

But let’s take a closer look at the fund in question (SMIFX). A few facts, courtesy of Morningstar:

  • It’s a U.S. equity fund of funds.
  • It has an expense ratio of 1.22%.
  • It has 141% annual portfolio turnover.

It’s important to note that the 1.22% expense ratio is in addition to the expenses charged by the funds it invests in. Even if we assume it invests exclusively in low-cost index funds, we’re looking at a grand total expense ratio of roughly 1.5% for U.S. equity fund. Ouch.

Assuming the fund invests only in funds with no sales loads or redemption fees, the 141% turnover doesn’t directly add to the costs of the fund. It does, however, make the fund decidedly tax-inefficient for anybody investing outside of an IRA or other tax-sheltered account.

Well-intentioned fund manager or not, I’d suggest looking for something with lower costs.

Same goes for financial advisors.

Similarly, I know for a fact that there are many good people working as financial advisors for major brokerage firms–Edward Jones, Wachovia, etc. These advisors not only mean well, but they sincerely believe that they’re serving their clients’ interests as well as any advisor can.

Still, I’d advise investors to steer clear.

If an advisor is paid on commission, he simply cannot give you unbiased advice. His compensation depends upon recommending commission-paying investments (typically, mutual funds with sales loads) regardless of whether they’re the best choice for you.

Good intentions only go so far.

When it comes to selecting mutual funds, it certainly doesn’t hurt to look for fund managers of good character. But that’s not enough. You also need to pay attention to costs and turnover–the two most successful predictors of future performance.

And when selecting an advisor, it is essential to find one of good character. But again, that’s not enough. Whether you need help developing an asset allocation or rolling over a 401(k), you need to find an advisor who’s in a position to provide you with unbiased advice, otherwise you’ll end up paying unnecessary costs for subpar investments.

About the Author: Mike Piper is the author of Investing Made Simple. He also blogs at The Oblivious Investor.

2 Responses to "“Good intentions” doesn’t cut it"

Mike,

Experience of Martha is so similar to Marion, she was taken for a ride by her trusted Wachovia financial advisor.

Ouch. It’s unfortunate that such an experience isn’t a rare thing.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC. He is also a regular contributor to Morningstar Advisor and Physicians Practice. To explore a long-term wealth advisory relationship, schedule a discovery meeting (phone call) with him.



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