5 ‘Sneaky’ Mutual Fund Behaviors That Erode Returns: Kenneth Kim

Working as a senior financial economist at the Securities and Exchange Commission opened his eyes to a raft of inefficiencies in the market, he says. That 1998-1999 experience and a stint as a consultant with the Securities Litigation Consulting Group inspired him to co-write "Infectious Greed: Restoring Confidence in America's Companies" (Financial Times Prentice Hall 2003), focusing on corporate governance issues.

In "Mutual Funds Exposed," Kim lays bare inherent fund flaws that lead to increased costs to investors. An updated version of the original 2014 edition – co-authored with William R. Nelson, EQIS co-founder – it instantly hit No.1 on Amazon's mutual fund-investing bestsellers list upon publication in April.

What does Kim propose as a better alternative to mutual funds? Nope, not exchange-traded funds. He touts instead separately managed accounts, wherein securities are directly owned by investors and which provide savings and significant tax efficiencies over ETFs.

Previously, SMAs were within reach of only high-net-worth individuals and institutional investors. Nowadays, they're available to the mass affluent by way of technology-based turnkey asset management programs (TAMPs).

EQIS, for example, offers — through FAs — customized portfolios that replicate the portfolios of about 70 institutional money managers and are appropriate for investors with an account size as low as $25,000.

ThinkAdvisor recently chatted with the affable Kim, on the phone from his office near San Francisco. Born in Korea, bred in Michigan, California, Missouri and Kansas, he is the recipient of a wide variety of awards, including "Professor with the Best Sense of Humor," bestowed by students of The State University of New York at Buffalo, where he taught for more than a decade. Here are excerpts from our interview:

ThinkAdvisor:  Would you have written "Mutual Funds Exposed" were you not with EQIS, a firm focusing on separately managed accounts as a better solution than mutual funds?

Kenneth Kim: Absolutely. The inherent flaws of mutual funds have been eating away at me for a long time. But working at EQIS was a nudge for me to finally sit down and write the book. What's the most important thing for financial advisors to know about mutual funds?

That they are notorious underperformers. A few years ago, it was discovered that they have numerous hidden costs that can be even larger than their disclosed fees and loads. The returns are always net of their fees, loads, hidden costs, tax inefficiencies and sneaky costs. So if, say, the market is up 8% and you have a mutual fund that tracks the market, you might be lucky to get 3% returns.

What "sneaky costs"?

In the last 10 years, there's been a lot of academic evidence pointing out the sneaky ways that mutual funds behave. Financial advisors need to be aware of these because sneaky behaviors come with costs that will be borne by investors. I estimate that these cost them 3.9%.

What's one of the bad behaviors?

"Window Dressing": Because mutual funds are so nontransparent, you get to know what's in the fund only four times a year, per regulations. And mutual fund management takes advantage of that. For example, when a security in a fund is doing horribly, right before quarterly reporting of the holdings, the fund will often get rid of that security, hiding the fact they ever invested in it. They don't want anyone to know that they picked this awful stock. Also, funds will buy stocks that have had great returns to make them look like they're good stock-pickers, when in fact they're buying these winners after they've experienced their runup.

How much does this cost investors?

Academic research shows that if funds weren't wasting their time with window dressing and [incurring] all the accompanying excessive trading costs, they could save clients 1% per year. One percent compounded over a 30-year period is of course a large amount.

What else is sneaky?

"Leaning for the Tape": This is analogous to sprinters at the very end of a race leaning their heads as far forward as possible to try to cross the finish line first. Mutual funds do that too: Right before quarterly returns' reporting, they'll buy up a bunch of current holdings and hope that because of price pressure, they'll be able to, temporarily, artificially inflate those values just to make the returns look good.

More ploys?

Here's one of my "favorites": "Misleading Track Record," or "Fake Incubation." Mutual funds say they create funds in incubation using their own money and test them before they're sold to the public — like pharmaceutical companies testing drugs before marketing them. But academic evidence has uncovered that what mutual funds actually do is make a dozen or more random funds with randomly selected securities, and wait and see what outperforms. Whichever one it is, that's the one they'll bring out and market as an outperformer.

But what about the other funds being "incubated"?

They'll hide them and act as if they never existed. So you think, "Wow, that stock they brought out is a real outperformer." But it didn't do well because of stock-selection ability. It was randomly created, and it randomly outperformed. Further, such funds eventually mean-revert in their returns and therefore become underperformers because they weren't outperforming for fundamental reasons. Any other sneaky behaviors?

"Cold IPO Buying": A quarter of mutual funds are created with investment banks. When the investment banking partners can't sell IPOs, they pressure the mutual funds to buy up the cold IPOs. Lots of evidence of this has come out in the last decade or so. However, much of this stuff was known to regulators for quite a while.