The Problems with Mutual Funds: The Little-known Truths and Three Ways To Protect Yourself

by Mark Skousen

The Problems with Mutual Funds: The Little-known Truths and Three Ways To Protect Yourself

By Dr. Mark Skousen, Chairman, Investment U

Monday, June 26, 2006: Issue #550

I'm here at the London Junto/Harvard Business Forum, speaking on two Bens Ben Franklin and Ben Bernanke. The Forum is a monthly lecture series sponsored by Nicholas Vardy, editor of the Global Bull Markets Trader and an American who lives in London. Nicholas used to run a mutual fund, and I asked him why he stopped. He then began to describe all the ridiculous rules that fund managers have to obey which hurt the average investor.

I learned this lesson many years ago. A friend had started a closed-end fund called the Fund for All Seasons, which invested in global stocks. The fund was performing poorly, and worse, it was selling for a substantial discount to net asset value (NAV), or the value of the individual stocks within the fund. The discount was over 15%. I suggested to my friend that he switch from investing in global stocks into bonds, because at the time most bond funds were selling at a premium over NAV. By doing so, presto, the All Seasons Fund would instantly jump 15-20% in price. Everyone would be happy - shareholders and management.

He shook his head. "Sorry, it can't be done," he said. "Why?" I asked. "Because by law the prospectus defines us as a global stock fund, and we can't have more than 10% in cash or bonds." To make the change would require the fund to change its prospectus and get it approved by the SEC and all 50 states. End of story. And so goes the many problems with mutual funds

The News on Mutual Funds Gets Even Worse

But the bad news doesn't end there for mutual funds. By law, funds are required to be "fully invested," which usually means that a mutual fund has only 2-3% of its funds in cash at any one time. This means that mutual funds are severely limited in protecting their shareholders during a time of a crash or a bear market. That's why even the best funds with excellent long-term track records and five-star ratings tanked in the past two months.

The Masters 100 Fund (MOFQX) is a good example of the restrictions imposed on a fund. Masters fund manager Ken Kam chooses stocks based on the abilities of the top 10 managers with a proven track record. (I encourage you to go to his website, where anyone anywhere in the world can start a "virtual" mutual fund and see if they can beat the market.)

Using this unique strategy, the Masters 100 Fund was doing a great job beating the market until the crash hit commodities and emerging markets. Even though his top 10 traders were selling and building a cash position, the Masters 100 Fund was prohibited by law from going into cash by more than 10%.

How to Protect Yourself From Mutual Fund Problems

Here are three ways you can protect yourself from these negatives about mutual funds:

1. Be your own money manager and invest in several mutual funds and individual stocks. Be prepared to take profits and use stop orders to protect you on the downside, in case there is a crash or bear market. I personally took profits and exited several of my favorite mutual funds during the most recent downturn.

2. If you want to be a long-term investor and not try to trade mutual funds, invest in a well-diversified "permanent" portfolio of index funds in a variety of categories: Consider a "permanent" portfolio of funds or Exchange Traded Funds (ETFs) in growth stocks, bonds, commodities and cash. For example, the Permanent Portfolio Fund (PRPFX) attempts to do this all in one fund.

3. Consider going with a money manager who selects individual stocks and funds. Minimums are usually quite high for this approach: $50,000 or higher. Use a money manager who will post the value and composition of each position on the Internet, so you can constantly monitor performance. And stick with money managers who have a proven track record over five years. Unlike a mutual fund, a money manager can go 100% in cash to protect you, if necessary.

Fortunately, some relief for mutual fund investors may be on the way with publicly traded hedge funds that have the capability of going short or heavily into cash during a bear market.

Until then, it's best to be your own money manager as much as possible. Studies have shown that individual investors often outperform professional money managers. After all, who is more interested in your own money than yourself?

Good investing, AEIOU,

Mark

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