in Mutual Fund Land
I need to be an adult, and adults invest in things
like stocks. I should invest.
First published here on March 26, 2013
It’s an early morning in September. The sky is dark. I am in bed.
And I am still very poor.
For graduate students, early mornings in September are the perverse cousins of early Christmas mornings. Instead of waking up before the sunrise to a Douglas fir, a loving family and presents, I wake up on an early September morning to a cold laptop, a snoring girlfriend and the promise of salvation: more student loan money.
I am refreshing my online bank account every few seconds so that I can see money flow from the federal government – the American people and their nation’s creditors — into my coffers. I have no funds of my own. I am dependent on the largesse of the state.
$10,831.32. Ten thousand bucks needs to last me for the next six months.
I am now less poor, but further in debt.
I consider the money’s weight in my bank account. I need to pay my cell phone bill, $84.69. Next week, I’ll have to buy a Metrocard, $104. And tonight I’ll imbibe at least 3 Guinnesses, $5 a pint.
Chinese takeout three nights a week, a new pair of Chuck Taylor’s, two nosebleed seats at the Barclay’s Center: This money will evaporate quickly.
It seems to me, on a humid September morning beside my girlfriend, who would like me to take her to that new French bistro ($32 for the foie gras and escargot, $75 for a couple of filet mignons and $45 for 2005 Château de Sancerre Rouge), or on a B&B weekend getaway ($200 for a couple of nights at the Shaker Hill Bed and Breakfast in New Hampshire, $140 for a rental car, $120 for a romantic dinner), that $10,000 is not enough. That little black dress that she always wanted costs $1,895. Not to mention $50,000 for a down payment on a starter home and $600,000 to send our two-point-five kids to Dartmouth and Vassar in 2043.
Like a normal American, I want more money.
I need to be an adult and adults invest in things like stocks and bonds and children. I should invest.
But invest in what?
A savings account is out of the question. The Federal Reserve pushed interest rates down so low that a boring CD offers 0.3 percent return on investment. I have $2,000 to play with. My yearly return would be worth a side of frites ($6) at that French restaurant.
How could I do better than that? Hedge funds are for really rich people, and I wouldn’t even know where to start if I had the money. There are something like 28,000 hedge funds in the country and each of them takes 2 percent of your investment and 20 percent of the profit – if there is any. I would need $10 million, at a minimum, to invest with Bridgewater Pure Alpha or Paulson and Co.
The stock market makes sense. The S&P 500 has gone up about 15 percent so far this year. In fact, the S&P has averaged a 7 percent gain a year since the 1950s.
But I want more than 7 percent a year. I want as much money as possible. Besides, there’s no glory in doing as well as the S&P. Anyone can do that. I want to be special.
There is just too much choice. It’s like walking into Ikea and seeing 13 different Swedish names for a pillow.
My girlfriend rolls over and knocks me in the hip with her elbow. The queen-sized Sultan Hogla costs $450 at Ikea. The black leather Karlstad sofa is $919. The Isala coffee table is $199.
I am frustrated and financially illiterate. I am a money cripple. I am Dorothy looking to escape to the green lands of Oz.
And I am not alone. Strewn across the world are hundreds of thousands of investors, which is to say middle managers yearning to build an extension on their kitchen or schoolteachers vacationing at Ocean City or construction workers in need of shoulder surgery. The problem is that these people are just like me: They have no idea what they are doing with their money, and they are scared to death.
Take the 401(k), the tax-free retirement saving vehicle. In a study, almost 60 percent of the staff and faculty at the University of Southern California reported that they took less than one hour to pick what kind of retirement fund they wanted to invest in or how much of their salary they wanted to contribute. A decision that will dictate the quality of their retirement, and three in five employees of a prestigious private school in the second largest city in the U.S. made their selection in less time than an episode of “The Sopranos.” Tuition at USC costs $42,162 a year, by the way.
Another retirement plan in the United Kingdom required no money from the worker; it was paid completely by the employer. If the world were rational, every single worker would have signed up for the plan. Instead, only half did. The other half never summoned the energy to sign up for a program that quite literally handed them free money.
People are dumb about long-term money decisions because there is just too much choice. It’s like walking into Ikea and seeing 13 different Swedish names for a pillow.
Anyone will go anywhere for digestible financial advice. In a chain of Texas supermarkets, employees at each individual supermarket had the same investment strategy, but the strategies varied from supermarket to supermarket.
“It turns out that most of the supermarket employees considered the store butcher to be the investment maven and would turn to him for advice,” wrote economists Shlomo Benartzi and Richard Thaler. “Thus, depending on the investment philosophy of the butcher at each individual location, employees ended up heavily invested in either stocks or bonds.”
People are looking for money answers in the meat department.
“Just put it in a mutual fund, that’s what my dad does, I think,” my girlfriend murmured to me in between a toss and a turn.
I know she doesn’t know what a mutual fund is, that she is parroting the phrase, that she is saying anything to let me let her sleep. But it makes sense.
A mutual fund is run by a professional money manager who raises billions of dollars from small investors and pension funds and uses that money to buy stocks from many companies.
The portfolio manager’s goal is to do better than the market as a whole. In return, the mutual fund owner takes a cut of my money, say 1.5 percent, as a fee.
What I’m really paying for, then, is genius. These guys pore over reams of a company’s SEC filings, obsess over its balance sheets, and drill the company’s senior officer – her plans for growth and market share and world domination. The mutual fund manager wears $30 argyle socks from Saks Fifth Avenue, works in a tall building and makes dolts like me a bit of money in the process.
At least that is how it’s supposed to work.
Perhaps no man was more important to the development of the modern mutual fund than Paul Cabot. Born in 1898, Cabot co-founded one of the first mutual fund companies a year after earning his M.B.A. from Harvard. State Street Investment Corporation went gangbusters in the second half of the 1920s, doubling the return of the S&P 500. When mutual fund laws and regulations emerged in the wake of the Great Depressions, Cabot was a chief counselor to Congressional legislators, a voice of authority. He was a man of principle in an era lacking in scruples.
He also changed the lives of millions of people.
A mutual fund uses its millions, or billions, of dollars (from thousands of people like me) to pursue a particular strategy. The fund can be filled with energy-only stocks or solely with foreign debt or dividend stocks or any concoction a fund portfolio manager can imagine.
Thanks to mutual funds, small-time investors like me have a chance to take a stake in America’s biggest companies or fastest rising companies or largest paying dividend companies without actually having to buy the companies themselves.
Right now, Apple is trading at a little more than $450 a share. By myself, I could buy four shares. There is nothing more juvenile than owning four shares of Apple. But I could put my $2,000 into some fund and come away with shares in Apple, General Electric and Exxon Mobile. That’s much less juvenile.
Five years after Cabot started State Street Investment Co., the mutual fund industry had a few thousand investors and a few million dollars. By the end of the 1940s, it was a $2 billion industry. Today more than 90 million Americans invest more than $11 trillion – with a T – in thousands of funds. That’s more dollars managed by companies like Vanguard and Fidelity than any national economy is worth, with the exception of the United States.
Started as a small-time financial service in Beantown 90 years ago, the mutual fund has become one of the most important financial innovations ever. If you plan on retiring someday or sending your daughter to Notre Dame or buying a house, you will one day in some fashion put your money in mutual funds.
I am young and poor and my penury is slowly strangling me. I grew up in the Washington D.C. suburbs and I want what my lineage portends – a life of liquid assets (cash in my wallet), fine things (filet mignon and Vermont Bed and Breakfasts) and financial security (cash in my bank account). I want to eventually have a tasteful four-bedroom, three bath, McMansion on an acre of land with clipped bushes, a 100-foot winding driveway and a maid. I want the good life.
So, I need someone smart to give my money to. The portfolio managers who run mutual funds hail from Harvard and Princeton and Stanford, and read hundreds of pages of analysis on the risk associated with investing money with company Y or the chance company X will be able to break into China. They are the grownups.
These professionals pour giant pools of our money into actively managed funds, that is, a mutual fund whose manager is constantly buying and selling securities to earn as much money as possible. The portfolio manager may be in charge of some tens of billions of capital and must allocate that money to stocks that will grow over the long haul. He is called “professional” because he makes his choices rationally.
“First you’ve got to get the facts,” Cabot said of his investment strategy.
“Then you’ve got to face the facts.”
Kevin Plank stepped up to the podium. Flanked by teleprompters, the ex-college football player’s bespoke suit clung to his bulking frame. Plank stood on the main stage of Lincoln Center’s opera hall. Even from row T, he looked like Hercules.
“We have a strict no-loser-talk rule,” said Plank, founder and CEO of Under Armour. Under Armour makes fleece-like shirts that football players wear underneath their pads. After 17 years, Under Armour is worth just under $2 billion. No loser talk needed.
This was my first time inside the opera hall, and I wasn’t there for “La Bohème.” But I wasn’t there for Plank, either. I was there for the 21st Annual Baron Investment Conference. I was there to see if I should give the host, Ron Baron, my $2,000.
Baron, the billionaire owner of the Baron’s Fund, is known as the Candide of Wall Street, forever optimistic, the man who goes long on the United States equities markets.
To me, he is the Wizard of Oz. I came to the investment conference to listen to the billionaire talk, but so far he hadn’t said a word. I had seen the world he created instead of the man himself.
The Baron Investment Conference was an eight-hour, multimillion-dollar pep rally for investors in Baron Funds. Approximately 4,000 investors showed up from as far as California to hear from CEOs, listen to the musical stylings of Broadway stars, eat “free” food, drink “free” coffee and be in the presence of Baron, whose mystique came from his wealth, which came from managing money for people like those in attendance. Baron spent a reported $100,000 to rent Avery Fisher Hall and seven figures for the Grammy-winner entertainment.
Baron can pay for the party because it is expensive to invest money with him. He charges, depending on the fund, around 1.5 percent of the amount invested as a fee. This is a lot of money, especially over 10 years, and could eat up to 20 percent of my prospective returns.
Like any good consumer, I needed to see with my own eyes if Baron was truly worth 150 basis points – as people in the financial business are determined to refer to 1.5 percent.
Harry Connick Jr. would be singing a set with a nine-piece band in Avery Fisher Hall (for those attendees with a green bracelet).
I did not fit in.
I was an intruder in a world filled with white-collared, white-haired suburbanites who were eager to embrace the warmth of a stable retirement.
Baron investors in the half-full theater liked what they saw. One success story, Under Armour, comprised 2.4 percent of the Baron Growth Fund and its stock was up 23 percent since November 2011.
“It took us 15 years to make our first billion, and two to almost make our second,” said CEO Plank. He showed promo videos celebrating Under Armour’s successful rise, then left the stage.
Out walked Baron. This was the moment I’d been waiting for – the moment Baron opened his mouth and I decided whether to give him my money. This was the moment I learned Baron’s secret, the moment I learned if he was worth a damn.
Instead, Baron announced that it was lunchtime. I would have to wait.
Baron told the crowd that Kristin Chenoweth was playing in the Koch Theater (for those attendees with orange bracelets), Joss Stone could be found in the Rock n’ Roll Theater (for those attendees with purple bracelets) and Harry Connick Jr. would be singing a set with a nine-piece band in Avery Fisher Hall (for those attendees with a green bracelet).
“Oh, I love him,” said a woman with a green bracelet.
I was swept outside by the egress of retirees, soon to eat pre-packaged couscous, a dry barbeque sandwich and a moist brownie. Pretty soon, Harry Connick Jr. was going to sing “The Way You Look Tonight,” while Chenoweth belted “Maybe This Time.” The rapt septuagenarians would crinkle their plastic bag of chips during the performance.
As I shuffled out, I looked over Baron’s promotional handouts. There was the Baron Growth Fund, Baron Partners Fund, Baron Focused Growth Fund, Baron Opportunity Fund, Baron International Growth Fund, Baron Asset Fund, Baron Real Estate Fund and the Fifth Avenue Growth Fund.
A double-sided sheet for each laid out the financials in charts and color-coded graphs. Words like “investment principles” and “long term perspective” and “capital appreciation” were strewn across the page. Each of the sheets made it look like Baron Funds was killing the market.
For the first 10 to 15 years, Baron was indeed a killer, making millions for his clients and billions for himself. But since 2007, these funds have done as well as, or worse than, the market. And that’s before taking into account management fees.
It’s difficult for me to assign value to Baron’s feast or famine streaks. One study, for instance, shows that based solely on chance, 10 percent of mutual funds will beat the market over a three-year period. That means that simply by existing, some funds will make their portfolio managers look brilliant.
Still, there are investors like Warren Buffet and Peter Lynch who have done so well for so long that it’s hard not to believe in supreme genius. Maybe Baron is like Buffet. Even economists recognize that some money managers are significantly better than average over time.
But maybe Baron was lucky for a while, and is now coming back down to earth. Maybe he tempted the gods for too long. Maybe his 49th-floor office in the GM building rose too close to the sun.
I don’t know. I still needed to hear him speak. I’d have to eat my lunch first.
Neoclassic economic theory is based on one simple premise: people are rational with their money. Consumers negotiate how much a product is worth to them based on the quality of the product and the amount of money they are willing to spend.
Left to his own devices, neoclassical economic theory says, a man who wants breakfast will buy a $2 bagel instead of a $3 one, if both bagels are equally delicious. This is absolutely intuitive. When I shop for cereal and I like corn flakes as much as I like Cheerios, I will buy whichever one is cheaper.
Neoclassical economic theory, however, is not right all the time. There are instances where havoc rages, the natural order of capitalism falls apart and nothing makes sense anymore.
This is especially true in the data-driven world of high finance. It turns out that the people in charge of your money are not as rational as they would have you believe.
For instance, stock markets across the world do better on sunnier-than-expected days. If neoclassical economic theory is correct, the weather should not matter. The reason it does, according to research by David Hirshleifer and Tyler Shumway, is that people, including stockbrokers, are more optimistic when the day is sunnier than expected.
The merry stockbroker goes to his office at 7 a.m. in a good mood, with a ruddier outlook on the world. He starts buying stocks. When brokers buy stocks, the demand for stocks goes up and stock prices appreciate. The sun shines, stockbrokers feel good, and they buy more stocks.
“They incorrectly attribute their good mood to positive economic prospects rather than good weather,” wrote Hirshleifer and Shumway.
And this wasn’t in one city during one particularly fluky year. The sunny-day phenomenon occurred in 18 different countries over a 15-year period.
That’s far from the only irrationality in the market. If neoclassical economic theory were correct, then traders who did poorly at stock picking would leave the business. They would become welders or farmers or something that stopped them from the unprofitable practice of buying high and selling low.
Nonetheless, some bad traders seem to persist. Economists Brad Barber and Terrance Odean looked at about 66,000 investors with accounts in large brokerage firms over a five-year period and found that brokers who traded the most earned the least – about five percentage points below the market.
Had those brokers stopped looking for the hot stock and bought an index fund – which simply mimics an index like the S&P 500 – and held onto it for five years, they would have improved their return by 36 percent.
Highly active traders gave up a lot of money for the pleasure of pushing the trade button. They believed they knew more than they did. They were wrong, and paid for it.
There are plenty of other ways for high-finance folks to act stupidly, i.e. to not make money. In a report released last May, the Kauffman Foundation, a non-profit that gives grant money to entrepreneurs and children’s education, decided after 20 years to reduce the amount of capital it invested with venture capital funds, which finance new businesses.
“Venture capital has delivered poor returns for more than a decade,” the report’s authors wrote. “VC returns haven’t significantly outperformed the public market since the late 1990s, and, since 1997, less cash has been returned to investors than has been invested in VC.”
Research by Harvard professor Shikhar Ghosh showed that 75 percent of firms backed by venture capitalists never make a return on investment. For the past 15 years, venture capitalists provided less value than anemic U.S. Treasuries.
The list goes on and on. Market analysts hired by the big banks are given to group-think and follow-the-leader tendencies in rating businesses – like a bunch of students cheating off the smartest kid in class.
The mutual fund universe is plagued by its own irrationalities. They are apparent when you compare actively managed funds to index funds.
When you give your money to an active portfolio manager, you are saying that the pro is smarter than the economy as a whole. If the S&P 500 index grows at 7 percent, you are betting the actively managed fund will grow at 9 percent. Beating the S&P 500, or another index, is the reason the actively traded funds exists. It’s why portfolio managers make millions and get to buy estates and go out to fancy restaurants instead of boiling Barilla’s pasta at home.
But as we have seen, it doesn’t always work that way; all those irrationalities start creeping in. On the whole, the index mutual fund – which merely replicates the composition of a stock or bond index – does at least as well as the actively traded mutual funds run by portfolio managers, at a fraction of the cost.
If you invest in an actively managed mutual fund, where a manager picks stocks or bonds, Gary Belsky told me, “There is no reason at all to assume that this person can pick stocks or bonds any better that you can.”
Belsky, author of “Why Smart People Do Stupid Things with Money,” thinks actively managed mutual funds stink.
“One thing we understand from research and study – nobody has consistently picked stocks better than the average Joe,” Belsky said. “No one can over time beat the market average, which means if you invest in a firm you have just as good chance of performing below average as you do performing above average.”
Every year, Standards & Poor’s publishes a scorecard that compares active funds to those that track some index like the S&P 500. “The only consistent data point we have observed over a five-year horizon is that a majority of active equity bond managers in most categories lag comparable benchmark indices,” wrote the report’s authors.
Imagine the same record of success in another endeavor, say sports. If I was paid $20 million to play third base for the Yankees, but for five years hit no better than .250 or hit no more than 20 homers a season, the Bronx faithful would revolt. I would not be worth my contract (see Rodriguez, Alex). Someone else could do what I did for much less money.
Barber and Odean found that actively managed mutual funds and high-trade investors do worse than their index-managing counterparts. “The investment experience of individual investors is remarkably similar to the investment experience of mutual funds,” they wrote. “As do individual investors, the average mutual fund underperforms a simple market index. Mutual funds trade often and their trading hurts performance.”
In an exhaustive analysis of the mutual fund universe, economist Mark Carhart created a database of diversified stock mutual funds from January 1962 to December 1993. He studied the fees that funds like Baron’s charged customers, the returns those funds generated and the likelihood that funds with high returns would match those high returns in the future. He systemically broke down the market to see if genius was real. His findings were straightforward.
“The results do not support the existence of skilled or informed mutual fund portfolio managers,” Carhart concluded.
Ron Baron stepped up to the microphone.
All conference long he had made his presence known, but not felt. He sat on the dais as Kevin Plank (Under Armour CEO) and Frank Coyne (Verisk Analytics CEO) and David Rubenstein (co-founder of private equity monster The Carlyle Group) talked to Baron shareholders about brand penetration and market share and growth.
Baron was the intermediary between the two groups – the investor and the investee, the audience and the actors. He was the matchmaker.
Like all matchmakers, he wanted the two sides to get along, to be simpatico, to fall in love. But the investors only knew the CEOs on stage through Baron’s omniscient eyes. They trusted Carlyle and Under Armour and Verisk because Ron trusted them.
As Baron prepared to speak, his portfolio managers, disciples, sat behind him. All conference long, I had heard the gospel of Ron Baron according to Cliff Greenberg (Baron Small Cap Fund), Andrew Peck (Baron Asset Fund) and Michael Kass (Baron Emerging Markets fund.)
Jeffrey Kolitch (Baron Real Estate Fund) told the 4,000 faithful that when Ron Baron met with a company’s CEO, Baron didn’t ask about the company, he asked about the executive. Baron cared less about income statements and more about what made that executive tick. Ron Baron cared about people.
Now I’d get to hear it from the mouth of god, not just god’s mouthpieces. Because I didn’t really know Ron Baron – yet. So far, he was just the man with the perpetual tan that the well off always have, the one they manufacture in St. Tropez. He was just one of thousands of billionaires. He looked so small on the stage that had held Rodolfo, Carmen and Don Giovanni.
I expected to be dismissive of Ron Baron when he finally addressed the audience – even though the man’s Fifth Avenue office looks over the Pulitzer Fountain and The Pond, and he passes a Lichtenstein on the stroll to his desk. But then he said, “Hi, My name’s Ron Baron.” I was captivated. He seemed so reasonable.
He said that Chairman Ben Bernanke’s quantitative easing at the Federal Reserve was raising stock prices, that the shale gas boom would lift Baron’s oil and gas-related investments. He said living standards would appreciate, that Americans would keep buying things and everything would be all right.
He said that Baron Funds was not interested in the hot deal or the new-fangled thing. Baron did not use high frequency trading, and his portfolio managers weren’t cooking up the latest high-tech investing gadget that would turn the world upside down and cause the next flash crash. He used common-sense investing techniques. He got to know the companies he invested in.
He said he cared.
Baron grew up in Brooklyn and went to Ebbets Field as a child. He was a good kid gone great. He was the investors’ best friend. He was their savior.
“If you want to be better than the market,” said Baron, “you should invest with an actively managed portfolio at Baron’s.” Baron hits home runs. Index funds bunt for singles.
I looked down at the glossy that Baron’s PR flaks handed out in the morning. Minimum investment: $2,000. I have $2,000.
Baron’s listeners stopped nibbling on their couscous and nattering to one another. Light beamed onto the stage.
And I let myself believe him.
Despite the fallibility of actively managed funds and despite the varied and unequivocal mistakes that professional money men have made with their money and despite the fact that most money managers are as good at picking stocks as a monkey throwing a dart at the Wall Street Journal, it felt good to have him talk to me this way. It felt like everything was going to be okay.
Baron concluded his talk with a Q&A session. A man from California asked about the fiscal cliff and a woman from Massachusetts asked about Bernanke. Baron avoided politics and gave swift answers in complete sentences.
I grabbed my bag and got ready to head for the exit, happy with what I had found. I knew the stats. I knew that Baron funds were slumping and more expensive than index funds. But if I tithed my money to him, I wouldn’t have to worry about it myself. If Baron lost my money, I could blame him rather than myself. He was a scapegoat.
The audience, unlike me, was restless. The flock in pew T only half-listened to Baron. There was a patch of empty seats here and there and those who were seated bleated to their neighbor or snacked on leftovers from lunch. The 4,000 were waiting for something else.
“It’s now time for the main event,” Baron said.
Baron’s listeners stopped nibbling on their couscous and nattering to one another. Light beamed onto the stage as the theater’s doors opened and attendees who had skipped Baron’s chat filed back to their seats.
The stage lights went dim. Pop music blared from the speakers. The 4,000 collectively whispered the name of the world-famous artist who was about to appear on stage on a late afternoon in Midtown Manhattan.
“I can’t believe she’s here,” one audience member said.
After a five-minute intro video, Celine Dion glided onto the stage in a flowing white bespeckled dress and started to sing. The seraph caroled and the crowd returned silent adulation.
I couldn’t believe it either. I tripped over a pair of feet as I exited stage left.
I had seen all I needed to see. Baron’s 4,000 thought they had invested with Ron Baron to make money. They really invested with him to be a part of the club. The Ron Baron Club.
I wasn’t in the market for a club. I don’t like Celine Dion, or Harry Connick Jr. I don’t need to hear CEOs talk up their companies or to eat pre-packaged plastic containers of couscous.
I was in the market for financial guidance, for a grown-up to show me the way to buy my girlfriend a Bergdorf’s little black dress or save for our not-yet-born child’s college education. Someday I want a house.
As I left the great Opera cathedral, I thought of Broadway star Kelli O’Hara hymning “Someone to Watch Over Me” earlier in the day as the 4,000 came back from lunch.
I’m a little lamb who’s lost in the wood
I know I could, always be good
To one who’ll watch over me
Ron Baron was the shepherd and the 4,000 his flock. I’m not yet ready to be religious. But I can see the appeal. It’s always nicer to think there is an angel on your shoulder. Everyone wants to believe that someone out there in the skies of Manhattan is answering their prayers for a secure retirement.
I don’t need angels. No matter how reasonable the Ron Barons appear, they don’t know the things they claim to. No one does.
My $2,000 will remain in my bank account and, thanks to inflation and low interest rates, effectively lose value. At least for now. At least until I grow up a bit. At least until I actually have some money to play with.
At least I understand bank accounts.
I reached into my wallet and felt around for the rumpled 20. I’ll buy my girlfriend a few Guinnesses when she gets home from work. Then we’ll go to Chez Moi for date night.