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Hi,

I was about to invest in mutual funds for my annual contribution to my Roth IRA when I read today's Fool article about the "Real Case Against Mutual Funds." It made me a bit nervous. Does the article have validity or is it just some hype for Fool funds? At first the article seemed convincing, but I was also thinking that it doesn't seem so bad to pay a large amount of fees to a company that makes you $3 million. I was thinking about Dodge and Cox, Oakmark, Vanguard, and Bridgeway--all funds that seem to be reasonable in terms of fees. I was wondering what others thought about the Fool article. Thanks.


Hey Dave,

Thanks for bringing this to our attention. I wouldn't have seen that piece otherwise, and having read it, I find it dismaying that such shoddy work is posing as "advice" on a site like this.

Let's take an analytical look at the article you mentioned, which is at http://www.fool.com/news/commentary/2006/commentary06061312.htm

The basic premise of the piece can be summarized easily: the higher the expense ratio of a mutual fund, the less benefit a fund shareholder gets from gains made by stocks in that fund's portfolio. Another way of saying this is that expenses decrease the performance of a mutual fund.

Besides the fact that this is mathematically obvious, it is also stated in virtually every guidebook, advice column, textbook, or casual message ever written about "how to shop for mutual funds." In other words, it is very old news. So, I believe what Paul Elliot is doing in that article is to throw in the journalistic equivalent of scary music, gory makeup, and special effects, to make something plain and familiar seem much newer and scarier than it really is.

Specifically, he creates a hypothetical scenario to illustrate his point, but his scenario is impossible to match with any real-world experience. He describes an imaginary mutual fund that owns only three stocks, all domestic big-caps, and which charges 2% in expenses.

I just spent a bunch of time with the premium fund screener at Morningstar. I asked for domestic stock funds with no more than 4% in bonds, and no more than 40% cash. I ruled out any fund whose holdings were simply other mutual funds, indexes, derivatives, or the like. After all, I was looking for a genuine mutual fund, as fully invested as possible, based on stock-picking and not indexing.

Well -- Morningstar reports NOT ONE domestic fund with so few stocks in it. In fact, I found only one mutual fund with less than 15 stocks (it had seven stocks, and hardly any investors). So, out of 5,000 funds that M* analyzes, not one even faintly resembles the one Elliot described!

So he is making a "straw man" argument right from the start. But it gets worse.

The next stage in his imaginary scenario is that this fund manager would hold the exact same number of shares in exactly the same three stocks, for ten years. Obviously, to accomplish that, the fund would have had to be frozen the whole time, with no new purchases and no redemptions.

I could go on, but we're already in Cloud-Cuckoo Land. There will never be such a fund, and if there were, nobody would buy it, especially not with a 2% expense ratio. As most of us here agree, if we pay up for expenses at all, it is usually to get access to expertise and management activity that we can't provide on our own. And many of those funds have achieved returns matching those claimed for the newsletter that his "article" is touting.

It is a very bad approach to marketing -- insulting the potential buyers! He makes the eternally-flawed argument, that we hear so often, that basically says you and I are too stupid to avoid buying bad mutual funds, and that we're therefore doomed to failure.

Here, I'll let him say it: "...let's face it, you're not going to buy into a miracle fund like the one I just described. Your fund manager won't be a genius. More likely, he'll be an Ivy League MBA looking to keep his job and follow the herd -- or worse."

What an insulting and presumptuous thing to say! Remind me to take Paul Elliot off my Holiday Card list.

But he's not done with the presumption: "Don't believe me? Look no further than the list of widely held institutional stocks. I guarantee you'll find at least two of the three we just discussed, plus General Electric (NYSE: GE), Intel (Nasdaq: INTC), and ExxonMobil (NYSE: XOM). Now, run down the top holdings in your mutual funds. See anything familiar?"

What condescension. I can skip most of my funds, because none of those stocks will be in the small-cap, mid-cap, REIT, International, Emerging Markets, or Bond funds that I own. So instead I'll just look at some big-cap funds that I kinda like, for differing reasons: CHASX, OAKLX, HOVLX, CAMOX, and PRBLX. (Chase, Oakmark, Homestead, Cambiar, and Parnassus).

I took all five of those funds, put $1000 of each into a portfolio on Morningstar, and did a stock-intersection X-ray. Guess what? NO Exxon and NO GE, at all! Two of the five funds hold a little bit of Intel -- $50 worth, out of the $5000 in this mock portfolio. I guess that blows Paul Elliot's assumptions out of the water, at least where yours truly is concerned.

But the nonsense continues. Elliot sneers that the managers of those same funds probably would not have been smart enough to buy and hold Electronic Arts (ERTS). Yeah, well probably not, Paul, since Electronic Arts is a SMALL CAP TECH stock, and would be unlikely to fall into the same portfolio with GE or ExxonMobil. Good grief!

From such logical gaps, I get the feeling that Paul Elliot does not understand how a good mutual fund investor might do some research, take a look at the economic climate, and then design a portfolio by choosing funds to fit specific needs. He does not demonstrate an awareness that many funds' managers are obligated by their charters to focus on specific market caps, sectors, or company valuations -- or that the quality of a fund manager should *absolutely not* be judged by whether that manager picked any given stock, as if a single stock could ever be some kind of litmus test of managerial intelligence.

Oh, and somebody should tell Paul Elliot -- the guy on the TD Ameritrade commercials is Sam Waterston. He's an accomplished and well-known actor, who deserves better than an off-handed dismissal as a "sour-faced know-it-all."

So, Dave, to answer your question... No, that article does not give me any qualms whatsoever about mutual fund investing. It does make me wonder what the Gardners are thinking, to turn that guy loose, popping off such off-handed put-downs, creating absurd scenarios to argue against, and belittling the intelligence of the readers here. It reflects badly on them, which is a shame.

There's one other thing that gets my attention, on reviewing it one more time. The author cites the performance of stocks picked by that newsletter over the past four years. Then he says:

"For the sake of argument, let's say you earned precisely that return for the next 20 years. If you managed to sock away $500 a year, you'd wind up with $193,186."

"For the sake of argument" is not, in my view, a sufficient warning to the investor/reader. It seems to me that there should be disclaimers of some sort, telling the reader that "the sake of argument" ALSO requires the acknowledgment that an investor could easily lose 24% a year on individual stocks, if things go bad. I believe a supposedly consumer-friendly outfit like this should tread a bit more carefully than that.

Anyway... Hope this helps! :-)
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