Part 9:  Investing in Investment Funds

Words: 1,268  Time: 6 Minutes

💥 Why This Matters

• Mutual Funds as Accessible Investments: Mutual funds, an affordable American innovation, enables investors to invest through diversified, professionally managed portfolios.

• Pitfalls of Chasing Past Performance: Past performance is a poor predictor of future success, and high-fee, high-turnover funds typically yield lower returns. Target low-cost index funds.

• Challenges of High-Performing Funds: Investors are advised to select funds with low fees, aligned management, and strategies that match their goals.

📝  Introduction

Chapter 9 of The Intelligent Investor explores the world of investment companies, primarily focusing on mutual funds.

It aims to guide the defensive investor in making informed decisions when considering this diversified investment avenue.

Graham delves into the different types of funds, their performance relative to the market, and the potential pitfalls to avoid.

But first let’s start with some definitions; and specifically how a Mutual Fund differs from Index Funds.

• Mutual Funds: A mutual fund is a broad term for any fund that pools money from many investors to invest in a diversified portfolio of stocks, bonds, or other securities. These funds are actively or passively managed and come in many varieties, including bond funds, money market funds, and equity funds.

• Index Funds: An index fund is a specific type of mutual fund (or exchange-traded fund, ETF) designed to track a specific market index, such as the S&P 500. They are passively managed, meaning they simply mirror the holdings of their benchmark index rather than trying to outperform it.

🚀 The Rise of Mutual Funds

Mutual funds, a purely American innovation, were introduced in 1924 by Edward G. Leffler.

They represent a cornerstone of financial democracy, offering an affordable, regulated, and convenient option for investors looking to invest in the stock market.

According to recent data, approximately 75 million Americans, or about 45% of U.S. households, invest in mutual funds. Furthermore, 16.9 million (13%) own ETFs, and 3.6 million (3%) own closed-end funds.

This statistic includes investments made through retirement accounts, such as 401(k)s and IRAs, which are popular vehicles for mutual fund investments.

Their tight regulation under federal securities law makes them a relatively safe investment choice. However, while mutual funds have their advantages, they are not without flaws.

For investors to truly benefit, it’s essential to navigate these funds wisely, as many underperform, overcharge, incur high tax burdens, and demonstrate unpredictable performance

🏃 Chasing Past Performances: A Cautionary Tale

 Similar to chasing “hot stocks” or the “latest trend” – many investors fall into the trap of selecting mutual funds based on recent stellar performance, assuming the trend will continue.

This belief arises from a natural human bias; we expect that a fund’s success will continue just as consistently as a skilled professional continues to perform well.

However, in the investment world, luck often overshadows skill.

This is why I tell readers if considering a fund manager – look at their performance over the past 10 years or ideally longer. 

A fund manager’s seeming “genius” can quickly diminish if the market conditions that initially favored the manager change.

Financial studies consistently reveal that past performance is one of the least reliable predictors of future success.

Based on what I’ve seen the past thirty years doing this – funds that exhibit high returns one year often struggle to repeat them.

Additionally, funds with higher costs and higher trading frequencies tend to yield lower returns.

Again, there are parallels to the results from “traders” vs “investors” with respect to stocks. 

Scholars suggest that buying funds based on recent gains is often counterproductive.

Instead, investors should focus on funds that offer economic and diversified holdings, especially if these funds are managed at lower costs.

Index funds, which aim to match – rather than beat the market – serve as a sensible alternative for investors seeking steady returns.

My personal recommendation is Vanguard’s VOO S&P 500 Index Fund. 

This has an expense ratio of 0.03% and matches the performance of the S&P 500 (which very few active managers will consistently beat over the long run)

☣️ Pitfalls of Winning Mutual Funds

Successful mutual funds face several challenges that can reduce their efficacy for investors.

High-performing funds often experience rapid inflows of capital, creating a need to allocate large sums of money without diluting returns.

This “asset bloat” may force fund managers to invest in stocks they would not typically consider, thus spreading resources thin.

Another issue is “migrating managers,” where a skilled fund manager is often poached by rival firms (not unlike football teams), leaving investors who originally joined for that manager’s expertise in the lurch.

Additionally, successful funds attract imitators, which can lead to market “herding,” reducing the fund’s ability to differentiate itself and increasing volatility.

Moreover, funds can experience rising operational and trading costs as they grow, particularly if their trades involve large blocks of stock.

In such cases, fees and expenses can consume a significant portion of profits, further straining fund performance.

This issue is compounded by increasing operating expenses that may not decline even when returns do.

Ultimately, this “cost drag” can significantly impact investor gains, especially when compared to low-cost index funds, which consistently offer lower fees and have shown to outperform most active funds over the long run.

📋 Selecting a Fund: Key Characteristics to Seek

Despite the challenges, certain qualities can make a mutual fund a strong investment.

• First, funds where managers are also major shareholders tend to align managers’ and investors’ interests, creating a mutual incentive to maintain high standards of management. Again, here we come back to Charlie Munger’s advice on examining aligned incentives. 

• Secondly, cost matters greatly; funds with lower expenses generally provide better returns over the long run.

• Third, funds that “dare to be different” by investing outside conventional portfolios can potentially deliver superior performance, provided the strategies align with investors’ goals and risk profile.

• Fourth, reputable funds sometimes close to new investors to maintain their quality of service for existing shareholders, avoiding excessive cash inflows that can dilute returns.

• Finally, funds that refrain from aggressive advertising may be a safer choice, as they are more likely to focus on performance than on expanding their investor base. 

By prioritizing factors like costs, risk, and management behavior, investors can make more informed choices.

📉 When to Sell a Fund

Investors should avoid reactive selling, as studies show that mutual fund investors often sell during downturns, missing out on potential recoveries.

Selling should be a considered decision and not solely based on a fund’s recent underperformance.

Red flags include sudden changes in the fund’s strategy, rising expenses, large tax liabilities due to excessive trading, or dramatic swings in returns.

While it may seem tempting to time the market or seek short-term gains, long-term patience is crucial to maximize returns.

Research suggests that investors who stay consistent over the long haul generally fare better than those who trade frequently.

Recognizing that occasional losses and downturns are normal can prevent premature selling and support a more successful long-term investment strategy.

 5 Key Takeaways

• Mutual funds offer accessible, professionally managed investments for investors.

• While affordable and regulated, they are often prone to high fees, tax burdens, and performance inconsistency.

• Many investors mistakenly chase funds with recent high returns, assuming they will continue, though past performance is an unreliable predictor of future success.

• High-performing funds face challenges like “asset bloat” and high fees that strain returns. To maximize investment value, investors should seek low-cost funds with aligned management, diversified strategies, and resist reactive selling.

• Low-cost index funds like Vanguard’s VOO can be effective for steady, long-term gains.