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The Great Mutual Fund Trap: An Investment Recovery Plan [Paperback]

Gregory Baer , Gary Gensler
4.3 out of 5 stars  See all reviews (24 customer reviews)


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Editorial Reviews

Amazon.com Review

If you've been burned on Wall Street (and who hasn't?) but still need a practical place to park your savings (who doesn't?), Gregory Baer and Gary Gensler have your number. While somewhat mistitled because it decries "active investing" in individual stocks as well as in mutual funds, The Great Mutual Fund Trap is nonetheless a clearly and even entertainingly written argument in favor of the alternative: investing broadly in stocks that mirror the performance of the overall market. During their years in private investment and with the U.S. Treasury and Federal Reserve, Baer and Gensler have come to believe the high fees and high risks that go with always trying to beat the market make "active investing"--be it constantly fiddling with your own portfolio or relying on professionals to do so for you--a no-win proposition. Instead, they say, you can actually improve returns by shifting to "passive investments" that offer lower costs and greater tax efficiency. After explaining why they feel as they do, the authors thoroughly describe the appropriate vehicles--index mutual funds, exchange-traded index funds, and several other products--in a way that makes these staid options seem almost exciting and gives interested readers all the tools they need to utilize them. --Howard Rothman --This text refers to the Hardcover edition.

From Publishers Weekly

Gregory Baer is the former Assistant Secretary of the Treasury for Financial Institutions, and Gary Gensler was once Under Secretary of the Treasury responsible for policies in the areas of U.S. financial markets, debt management and financial services. The two have teamed up to write The Great Mutual Fund Trap: An Investment Recovery Plan. Their book is meant for Americans who invest in the stock or bond market as a means to achieve long-term goals-such as paying their children's college tuition or securing their own retirement-but who, say Baer and Gensler, are paying unnecessary fees and running needless risks. Wishing to alert consumers to the traps that await them in financial markets, the authors offer alternatives and new opportunities for investors to improve returns and diminish risks, such as moving from "active" to "passive" investment, investing in international stocks, distrusting "hot funds" and investing in index funds. Conversational and easy to read, Baer and Gensler present realistic advice that will be useful to everyday investors.
Copyright 2002 Reed Business Information, Inc. --This text refers to the Hardcover edition.

From Library Journal

Smart Money claims that Gensler is one of the 30 most powerful people in investing, so we should listen when he says that mutual funds are no good.

Copyright 2002 Cahners Business Information, Inc.

--This text refers to the Hardcover edition.

Review

"A compelling work that takes a hard look at how Americans invest their money, and suggests better options. A serious book by serious people, The Great Mutual Fund Trap also contains practical and humorous illustrations guaranteed to engage any reader."
---Lawrence Summers, former Secretary of the Treasury

"The folks at Fidelity are not going to like this book, but anyone who still invests via an actively-managed mutual funds or who buys variable annuities or who favors Social Security privatization should read it."
---Andrew Tobias, author of The Only Investment Guide You'll Ever Need

"Mutual funds have brought millions of Americans into the investment markets--and for that alone they deserve much praise. Unfortunately, the returns that many of these investors have received have been less than spectacular. The Great Mutual Fund Trap exposes many of the flaws that drag down fund performance and suggests ways that investors can tune out the noise and focus on meeting their long term goals. The mutual fund industry isn't going to like this book one bit, but its story needs to be heard."
---Don Phillips, Managing Director, Morningstar, Inc.

“In this fascinating book investors will get a new take on how the odds are stacked against them by Wall Street's vested interests. Gary Gensler and Gregory Baer, two of the stars of the Treasury Department during the Clinton years, tell consumers how to avoid the traps and make the markets work for them with less risk.”
---Arthur Levitt, former Chairman of the U.S. Securities and Exchange Commission


From the Hardcover edition.

From the Inside Flap

Convinced that your star mutual fund manager will help you beat the market? Eager to hear the latest stock picking advice on CNBC? FORGET ABOUT IT! The Great Mutual Fund Trap shows that the average mutual fund consistently underperforms the market, and that strategies for picking above-average funds -- everything from past performance to expert rankings -- are useless. Picking individual stocks on the advice of brokers and analysts works no better. The only sure things are the fees and commissions you?ll pay.

Fortunately, the news is not all bad. Investors willing to ignore the constant drumbeat of ?trade frequently,? ?trust the experts,? and ?beat the market? now have the opportunity to do better. Using new investing products investors can earn higher returns with lower risks.

Drawing on their years of Wall Street, Treasury and Federal Reserve experience, Gary Gensler and Gregory Baer offer a fresh and realistic look at how money is managed in America. From new indexing strategies to risk-managed stock selection, The Great Mutual Fund Trap offers investors an escape from high costs and immunity from seductive marketing messages.


From the Hardcover edition.

From the Back Cover

Praise for The Great Mutual Fund Trap

"This is a must-buy. It should be in every Main Street investor's library. In fact, The Great Mutual Fund Trap is so good I could cry. "What distinguishes The Trap is this: While most recent books on investing and personal finance focus on Wall Street as the evil giant, this one focuses on America's new evil giant, the mutual fund industry, which for years has portrayed itself as Main Street's protector against Wall Street's robber barons. "Not so. As Gensler and Baer point out, it's becoming painfully clear that the fund industry is emerging as the fund investor's worse nightmare…" --Paul B. Farrell, CBS MarketWatch.com

"In this fascinating book, investors will get a new take on how the odds are stacked against them by Wall Street’s vested interests. Gary Gensler and Gregory Baer, two of the stars of the Treasury Department during the Clinton years, tell consumers how to avoid the traps and make the markets work for them for less risk."

—Arthur Levitt, former Chairman of the U.S. Securities and Exchange Commission, and author of Take on the Street

"This wonderful book explodes many of the myths that impoverish mutual fund investors. Its hard-hitting message may be only common sense, but it will assure you of long term investment success."

—John C. Bogle, founder of the Vanguard Group

"A compelling work that takes a hard look at how Americans invest their money and suggests better options. A serious book by serious people. The Great Mutual Fund Trap also contains practical and humorous illustrations guaranteed to engage any reader."

—Lawrence Summers, former Secretary of the Treasury

"Mutual funds have brought millions of Americans into the investment markets—and for that alone they deserve much praise. Unfortunately, the returns that many of these investors have received have been less than spectacular. The Great Mutual Fund Trap exposes many of the flaws that drag down fund performance and suggests ways that investors can tune out the noise and focus on meeting their long-term goals. The mutual fund industry isn’t going to like this book one bit, but its story needs to be heard."

—Don Phillips, Managing Director, Morningstar, Inc.

"The folks at Fidelity are not going to like this book, but anyone who still invests via actively managed mutual funds or who buys variable annuities or who favors Social Security privatization should read it."

—Andrew Tobias, author of The Only Investment Guide You’ll Ever Need

"The Great Mutual Fund Trap explains how you avoid wasting remarkable amounts of time and money in a futile search for the mutual fund or money manger that is going to beat the market. It does the job in clear English but without oversimplifying." --Charles Rossotti, former Commissioner of the IRS

"The insights the authors gleaned as watchdogs [for the U.S. Treasury] give this well-organized, well-researched book a heft that many investment primers written by fund-industry insiders typically lack. "With a light touch and a conversational tone, Baer and Gensler do an admirable job of maintaining a quick pace. …. For investors still suffering a hangover from the bull-market party of the late 1990s, this book is medicine that should be quite easy to take." --Amey Stone, BusinessWeek Online "[An] excellent new book…makes a compelling case for low-cost, tax-efficient index investing no matter how much or little money you have."

—Humberto Cruz, Ft. Lauderdale Sun-Sentinal

"For investors still suffering a hangover from the bull-market party of the later 1990s, this book is medicine that should be quite easy to take."

—BusinessWeek Online

"Conversational and easy-to-read, Baer and Gensler present realistic advice that will be useful to everyday investors."

—Publishers Weekly

About the Author

Named by Smart Money magazine as one of the most powerful people in investing, Gary Gensler was the lead at the U.S. Treasury Department, responsible for policies in the areas of U.S. financial markets, debt management, and financial services. An eighteen-year veteran of Wall Street, he was co-head of finance at Goldman Sachs and one of the youngest partners in the history of the firm. Gregory Baer was Assistant Secretary for Financial Institutions at the U.S. Treasury Department and helped to modernize the nation’s financial service laws. He previously served at the Federal Reserve Board.


From the Hardcover edition.

Excerpt. © Reprinted by permission. All rights reserved.

Chapter 1

Money Management in a Nutshell

Finance, N. The art or science of managing revenues and resources for the best advantage of the manager.
--Ambrose Bierce, The Devil's Dictionary

An Analogy

Every day there is a parade of money managers interviewed on CNBC or featured in Money or similar magazines. Every time we see them, we can't help but think of flipping coins.

Imagine that, instead of picking stocks, these scores of men and women each flipped one hundred coins per day, with the goal of producing the maximum number of "heads" possible. Viewers tune in to see who's doing well and bet on their favorite flippers.

Over time, the flippers' task is essentially hopeless: statistics doom them to an average performance of 50 percent heads. If you observe them on only one day, though, there will be winners and losers. While most will have around 50 heads, some will have 57 or 43.

Now suppose that some of the coin flippers are permitted to raise the stakes of each given flip by taping up to five coins together. For example, if one tapes four coins together, each flip will yield either four heads or four tails. Now, we might expect some of our flippers to produce 60 or 64 (or 40 or 36) heads in one day. By taping the coins, they are taking on risk (the possibility of four tails at once) in return for the possibility of reward (four heads).

Imagine, then, the Coin Flipping News Network (CFNN), giving us twenty-four-hour-a-day coverage of the flipping market. In comes coin flipper Lee with 56 heads, touting her latest tactic--say, many revolutions of the coin, with three taped together. Long forgotten is last week's guest, who had favored the few-revolution, one-coin-at-a-time tactic that worked so well during the last 500 flips but is now seriously out of favor. "Momentum" viewers favor those who have recently had more heads, while "value" viewers favor those who have recently had more tails.

Above all, viewers are assured that they are not capable of flipping the coins themselves--that they must rely on the experts to do it for them. And they are convinced that they should never be satisfied with just 50 percent heads--that is, "market" performance.

The Reality

The current state of money management is similar to this example--only worse. The returns for money managers are like those of our coin flippers. Most tend to stay close to the mean, while riskier funds tend to produce more volatile returns that balance out over time. The difference, though, is that whereas coin flipping is free, money management is not.

For that reason, the chances of your money manager beating the market are small. Evidence suggests that the average actively managed mutual fund underperforms the market three years out of five. According to data at Morningstar (which maintains a comprehensive database on fund performance):

* 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 500 Index (a measure of the U.S. stock market) by 1.9 percentage points per year (8.8 percent for the funds, and 10.7 percent for the index).1

There were 623 actively managed stock funds with a ten-year record. Their average annualized performance trailed the S&P 500 by 1.7 percentage points per year (11.2 percent for the funds and 12.9 percent for the index).*

* These figures include the sales loads charged by many funds. Loads are akin to brokerage commissions and come straight out of your returns. They are charged by many funds when you either buy or sell shares of the fund. Even with those loads excluded, however, the average five-year return trailed the S&P 500 by 1.4 percentage points per year, and the average ten-year return trailed by 1.4 percentage points per year as well.

Looking over a longer period of time yields a similar result. Excluding sales loads, the 406 actively managed stock funds that had been around for fifteen years or more trailed the S&P 500 Index by 1.5 percentage points per year.

* None of these aggregate numbers includes failed mutual funds, which would tend to have poorer performance and bring the averages down significantly. The exclusion of these mutual funds is called survivorship bias. The most comprehensive study of survivorship bias concluded that it inflates industry returns by 1.4 percent over a ten-year period and 2.2 percent over a fifteen-year period. With returns corrected for survivorship bias, the average actively managed funds trail the market by about 3 percentage points per year.

How can such a clever, hardworking group of fund managers trail the market by 3 percentage points per year? It's actually rather simple. The collective performance of stocks held by actively managed mutual funds, prior to any direct or indirect costs, generally will equal the performance of the market as a whole. With around $3 trillion in stock holdings, these funds basically represent the market.

But then along come management fees, trading costs, and sales loads. All of these costs weigh heavily on actively managed funds. The failure of almost all money managers to earn back their costs does not make them crooked or stupid. The problem is that their direct and indirect costs severely handicap their performance.

Nonetheless, each year some money managers will outperform the average fund, and even the market as a whole. The question is, can you identify these managers in advance of their market-beating performance? There is no reason to think so. As an individual investor, you have no comparative advantage in choosing those managers. In other words, there is no reason to believe that you will do any better a job picking stock pickers than you would picking stocks. If you can't do the latter, why would you expect to do the former?

Humorist Tony Kornheiser illustrated this point in a column about the trauma of the 2000-01 bear market.

My friend Tom, who has all of his money in mutual funds, panicked when somebody on the Today show said: "Your mutual fund is only as good as the manager investing the money. If your fund changes money managers, you need to check out the new manager." Tom pointed out, "If I was smart enough to check out my money manager, I wouldn't need a money manager."

Exactly!

Most investors simply choose funds based on past performance, but past performance truly is no guarantee of future results. The fact that a fund has outperformed the market for the past year, five years, or even ten years turns out to be a very poor predictor of whether it will outperform the market in the future. Funds that are above average for a time tend to regress to the below-market performance of the average fund.

Let's go back to our coin-flipping example. There were about 1,100 stock funds in 1991, and we know that each year about two out of five such funds (40 percent) have outperformed the market. If the identity of those 40 percent is just like coin flipping--that is, produced by random chance--how many funds would we expect to outperform the market each and every year over the next ten years? (In other words, how many beat the market in 1991, 1992, 1993, all the way to 2000?) Simple statistics tell us that by random chance between 0 and 1 fund should outperform the market each and every year.

That probably seems an improbably low number to you. But what has happened in reality? Over the ten years 1991-2000, only one fund (Legg Mason Value Trust) outperformed the S&P 500 every year. While we are happy for Legg Mason and its manager, Bill Miller, we view that outcome as roughly in line with random chance and as an indictment of active fund management. To the financial media, that outcome is a vindication of active fund management, and profiles of Bill Miller are everywhere. We'll let you decide.

The story is no better when it comes to picking individual stocks. Over a lifetime, the average individual's stock picks should return something close to the market, before costs. Sadly, the research shows that individual investors tend to churn their portfolio in an attempt to beat the market, incurring trading costs and taxes that radically diminish their returns. Investors also fail to construct broadly diversified portfolios, thereby running risks for which they do not receive commensurate rewards. In the end, they wind up trailing the market almost as badly as actively managed funds.

The rise and precipitous fall of Enron--once the seventh largest company in America--has provoked public debate on accounting practices, corporate responsibility, and numerous other issues. But for individual investors, Enron should provide two humbling lessons about the folly of trying to beat the market by picking stocks. First, in October 2001, less than two months before Enron declared bankruptcy, nineteen of the twenty-two analysts who covered the stock rated it a "buy." Critics have charged that these ratings were motivated by the investment banking business that Enron dangled before the analysts' firms. Wall Street has vigorously denied those charges. In fact, Wall Street should have welcomed the allegations as a distraction from an even more embarrassing alternative. The alternative, of course, is that analysts simply don't know a lot more than the rest of the market about the stocks they cover. Enron analysts who testified before Congress claimed that they couldn't be expected to discover problems that the company was deliberately hiding, but we suspect that many investors are relying on them to do exactly that.

The second, greater, lesson of Enron is the value of diversification. Some investors have reacted to Enron by expressing outrage with the accounting profession, corporate governance, and Wall Street; they have questioned whether they ought to invest in a market where Enron-like abuses can go undetected. We can certainly understand investors being outraged, but part of the risk of stock investing ...
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