Thursday, December 8, 2011

Occupy mutual funds?

Tom Petruno recently wrote an article in the LA Times where he wonders why the anger towards banks has not spilled over to mutual funds.  He brings up the question of how many mutual funds could truly justify their fees.

We think this is a very good point.  Take a key example of mutual funds systematically overcharging: closet indexing.  Let's do a back-of-the-envelope calculation to get at the scale of this problem.

According to ICI, there is about $5 trillion in US stock funds.  The average stock mutual fund charges a fee of about 1.3%.  A passively-managed index fund, on the other hand, can charge about 0.2%, so if your client buys a closet indexer, your client is paying about 1.1% more than needed.  According to the influential Cremers and Petajisto paper, about 30% of equity funds are closet indexing and the problem is increasing.

Scale of the problem:
$5T × 30% × 1.1%  =  $16.5B

That's right — the problem of closet indexing destroys over $16 billion per year in value.  That's money taken out of the retirement accounts of millions of Americans and put into the accounts of mutual fund managers who aren't really even picking stocks.  Seems rage-worthy to us.

Wouldn't you like to make sure the funds you recommend are not closet indexing?

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