ETF Investing Guide: How to Run a Mutual Fund Company

To get a clearer understanding of mutual funds, imagine you switch roles from customer to provider. Now ask yourself the following question: What’s the best way to run a mutual fund company?

Here’s my suggestion. First, make sure you seed a lot of individual funds, ensuring that the funds take different approaches to the market by emphasizing different sectors and stocks. With enough funds of differing styles, you can safely assume that some of your funds will do well, some OK, and some poorly.

Next, promote the funds with the best performance and downplay the funds with poor or mediocre performance. Journalists love writing about the best performing funds; if you have enough funds, some of yours are sure to be winners and to attract plenty of media attention. Hopefully, positive publicity about your market beating funds will attract investors’ money.

Now, if these winning funds subsequently crash or just under-perform the market, don’t worry: you can merge them into some of your other funds which have now risen to the top (defined as those with the best three or five year records). Don’t worry if the fund you are merging out of existence has $3 billion in it, and the fund you are merging it into has only $300 million in it; once the merger is complete you can claim the track record of the smaller fund while stating that the fund is a $3.3 billion fund.

Alternatively, you can start a few new funds to capture the latest stock investing fads: technology in 1999, dividend-paying funds in 2003, just choose! Launch a new fund, and merge the failures into it. Hopefully investors in the failed fund will be too lazy to withdraw their cash when they receive the letter informing them of the merger.

Next, promote your brand by advertising the Morningstar and Lipper ratings of your most successful funds. Never attempt to publicise how many funds you’ve shut down or merged, or what the aggregate, dollar-weighted performance of all your funds has been. And as investors respond to advertisements containing lists of your top rated funds by committing their savings even to your under-performing funds (“This is a great fund company!”), rest assured that you’re in a virtuous cycle: more advertising = more capital inflows = more fee income = more advertising.

And finally, if you’re really skilful, you’ll even be able to raise your fees to finance a heavier advertising budget, compensate brokers for pushing your funds on their clients, or increase your profitability.

There you have it: a fund company with excellent Morningstar ratings, investor funds pouring in, steep fees (justified by the performance, of course), and juicy profits.

But notice that this business formula, while successful for fund companies, is the exact inverse of investors’ interests. Since in aggregate mutual funds are unlikely to outperform the market through stock picking, increased advertising simply leads to higher expenses and thus to worse performance. And encouraging investors to focus on Morningstar ratings leads them up a blind alley.

There's another problem with fund companies pushing Morningstar ratings. If you, the investor, use Morningstar ratings to swap into and out of mutual funds in a taxable account (the same way people buy and sell individual stocks), you’ll realize capital gains too early (perhaps leading to higher tax rates) and destroy your compounded long-term performance by paying tax earlier than otherwise necessary and maybe even short-term capital gains taxes at high rates.

To make matters worse, if you swap into and out of funds with upfront or backend loads (often about 5%), you’ll dramatically increase the total fees you’ll pay.

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