November 18, 2003

#133: this time we agree with Paul Krugman

P. Krugman

This is one of those rare occasions when we agree with Paul Krugman, except he did not go far enough in criticizing the Mutual Fund industry in Funds and Games (11/18/03). The cheaters in the mutual fund industry should be punished severely and, if the law allows it, go to jail. But the mutual fund problem in the US goes much deeper. These funds have been getting by with smoke and mirrors for years.

To put it simply, mutual funds are overpriced and don't deliver. Anyone who has seriously researched the problem (the academic financial literature is full of such studies) finds that mutual fund managers cannot consistently beat the broad market averages. They get by on aggressive marketing, brokerage kick backs that border on corruption, and exploiting the natural desire of investors to "beat the averages." In America no one wants to be average!

The answer, however, is simple and getting simpler. For years there have been inexpensive index funds that replicate the various market averages for investors. Fidelity and Vanguard are leaders in this area and have many no-load index funds. Just check their web sites. These funds are growing in popularity with both individual investors and institutions who are tired of getting ripped off by managers promising more than they can deliver.

Historically, there were valid criticisms of index funds for being too broad to be useful to those investors who wanted to focus on just certain industries or geographic regions or companies of a certain size (large cap, small cap, etc.). But now there are ETFs (Exchange Traded Funds) which are bundles of individual stocks that trade as units. One example is SPDRs, or Standard and Poors' Depository Receipts. These are ETFs that replicate a variety of S&P indexes including the S&P 500 in its entirety, and also sector-specific SPDRs that carve up the S&P 500 into separate industry groups. For techies there are Qubes (QQQ) that do the same for the technology-laden Nasdaq-100. And this is just the beginning. There are ETFs on just oil services stocks, just transport stocks and just about any other sector that comes to mind. More can be read at Morningstar or Indexinvestor.

You can still lose money, of course. But the point is there are more and more alternatives now to the bullshitting, high-fee mutual fund manager. The recent scandals should accelerate the trend to these obvious alternatives.

[The Truth Squad is a group of economists who have long marveled at the writings of Paul Krugman. The Squad Reports are synopses of their discussions. ]

Posted by John Weidner at November 18, 2003 12:22 PM
Weblog by John Weidner