The Buy-and-Hold Myth: It's Not About the Money

Consumers hate paying for something they do not get.

So why is it that too many mutual fund shareholders don't complain when they pay for active fund management, but instead get sub-standard investment returns?

Most shareholders do not make this comparison and it is a very costly mistake. So how can a shareholder tell when their fund is failing to perform?

Shareholders can compare their fund's performance to the fund's own stated benchmark. By definition, a benchmark is a single index or a combination of a few indexes, which the portfolio manager picks to compare their performance. These comparisons are important since they determine how a fund is ranked and more importantly, how a fund manager gets compensated.

This idea of benchmarking comes from navigation in which a moving body (a ship, for instance) needed a constant to guide its direction, speed, and course. This constant could have been true north on a a compass or a landmark. That's one reason lighthouses were built.

Mutual fund investors forget about this centuries-old concept when it is time to compare the progress of their actively-managed mutual fund. This is more crucial when an investor is paying for active management, but the fund misses the mark. To use the old nautical comparison (which is the valid marketing theme for Vanguard and some other funds), the ship is off course. For some funds this is minor. For other funds, this is the course of the Exxon Valdez.

If you want to see how your fund has compared against its own benchmark, visit the lemonlist site. You have to go through a free registration, but it is a simple way to see if your fund, or entire fund family, is off course. You can make the missed-benchmark comparison over various time frames.

But if your fund is off course, you have to take action.

The Buy-and-Hold Myth
What should you do if your fund has missed its benchmark?

Depending on how many times it has missed its benchmark, I would not be afraid to dump it.

This is contrary to what a typical mutual fund marketing department would say, and certainly your financial rep would urge you to "stay the course," (another over-used nautical term.)

The mutual fund industry loves the old "buy-and-hold" theme because it reduces any discussion about redemptions.

The mutual fund industry hates redemptions. The word alone leads financial reps and mutual fund execs to make the sign of the cross used to fend off Dracula. Why the emotional response to switching your money to another fund, or even worse, switching your fund assets to another fund company?

Mutual funds are paid on assets under management. When you redeem your funds, company assets decline. Worse, when the stock market declines, fund asset values decline, which also reduces the fund company's overall profitability.

Mutual fund companies cannot control the stock market, but they can control your behavior. This is another example of how the fund company has a competing set of interests which do not necessarily align with you, the individual investor.

In a recent special article, "Thrift Nation" in Time magazine (April 27, 2007, page 26), a broker named Matt Felber, 39-years-old, is quoted as saying:

"One of my clients--45 years old, a top executive--e-mailed me, 'Should I sell everything?' I wrote back, 'No, you're fine, you can ride this out.' His return e-mail said, 'I knew that was the right answer.' I've been telling alot of people that they're going to be O.K. They need to her that right now."

This is exactly what you would expect from a financial adviser, and it is the wrong advice, in my opinion.

You cannot read too much into this short quote, but if Felber was not following the old industry line, he could have looked into the client's individual holdings (funds and stocks), and dumped ones which were going to lead or lag behind any cyclical sectors. An engaged adviser would have dumped the ones which would decline more or else lag any recovery, and kept the holdings which would have led the recovery.

It's Not About the Money
So why does the fund industry love the-buy-and hold-slogan?

An obvious answer is that the easiest way to do business is to do nothing. The market will recover, so take the broken elevator all the way to the basement, wait for the repairman to come fix it, and when he does his work and the spare parts arrive, you will eventually be above ground.

That's the astute recommendation you get from the mutual fund industry and too many financial advisers. Their position is that as long as you stay in the broken elevator, everything will be OK for them. The more passengers, the better the compensation. The passengers, however, have a different story to tell.

By coincidence, Mr. Felber's buy-and-hold advice appears on the same page as advice from a blackjack and roulette dealer (Monica Williams, 32-years-old) in Las Vegas. Her opening quote about the casino business is "Most people people come for the good time, and it's not all about the money."

Mr. Felber could have used the exact same quote to his client. The buy-and-hold is not about the money. Sure, the fund industry abhors market timing, another bugaboo which buttresses the do nothing investment philosophy, but that gets us back to the job of active managers. As a fund shareholder, you are paying for active management, so you should get returns which are above the benchmark index.

If not, take the good advice from the blackjack dealer and acknowledge that when it comes to mutual fund investing, too many people just come for the good time.

Unfortunately for too many mutual fund shareholders who succomb to the buy-and-hold rhetoric, it is certainly not about the money.

--Chuck Epstein
cepstein@prodigy.net