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

The prolific ex-professor takes relish in lifting the curtain on mutual funds' tactics that he says can cost investors big time

Sneaky mutual fund ploys include "window dressing" and "fake incubation," Kim says. Sneaky mutual fund ploys include "window dressing" and "fake incubation," Kim says.

“Infectious Greed.” “Mutual Funds Exposed.” Juicy supermarket tabloid headlines? Hardly. They’re two financial books written by Kenneth A. Kim, PhD., one of the top 1,000 finance scholars of the last 50 years, according to a study by professors at Saint Joseph’s and Trinity universities.

Kim, 48, spent two decades in academic research catching inefficiencies in securities markets and the financial industry. Now, with his book, “Mutual Funds Exposed: What You Don’t Know May Be Hazardous to Your Wealth” (EQIS Capital), the prolific ex-professor takes relish in lifting the curtain on mutual funds’ sneaky behaviors, as he calls them, all of which bring costs to investors that erode their returns. Kim describes what he deems the Top Five crafty maneuvers in an interview with ThinkAdvisor.

An in-demand speaker around the globe, Kim, who for two decades taught finance at a total of 16 universities worldwide, has published 50 academic research papers about finance, mostly exposés.

In 2014, he joined EQIS Capital Management, based in San Rafael, California, as chief financial strategist. Kim continues to champion governance and proper securities regulation and is an outspoken critic of bailouts.

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.

How do you know?

About twenty years ago, when I worked for the U.S. Securities and Exchange Commission in the chief economist’s office, the busiest group were the economists who were always looking into mutual funds because it seemed like, left and right, they were always up to some no-good. So the [SEC] was always busy investigating mutual funds and pursuing them for bad behavior.

Is that SEC group still active?

Oh, yes. What really changed things was the WorldCom and Enron debacles. They were a cry for more oversight. So all of a sudden, the SEC’s budget just about tripled. I’m sure that mutual funds are still a major [vehicle] they’re investigating because the SEC has oversight of mutual funds. Consequently, that area is always going to be important for them to monitor.

What else is a sly mutual fund behavior?

“End-of-Quarter Hail Marys,” or as academia calls it, “Risk Shifting”: Right before quarterly reporting, if a mutual fund’s returns don’t look good or they’re just tracking the benchmark , the fund will take a huge gamble to see if they can eke out a little more return so they’ll have something to brag about. It’s like a Hail Mary desperation pass in football. Often these large gambles don’t pay off. So again, mutual fund investors lose money.

You estimate that such bad behaviors, which include unnecessary trading, cost investors 3.9%. Any other fallout?

They induce short-sightedness in that mutual funds are [indulging in] these behaviors just for the quarterly reports rather than investing with a long [time] horizon.

But why do so many investors still gravitate to mutual funds?

Years ago it was an easy way to get your hands on a professionally managed, diversified portfolio. Also, the mutual fund industry paid a tremendous amount of money advertising itself. Mutual funds have been around for 100 years. You’d think that by now, there would be a better way to invest. And there is. That’s why ETFs and separately managed accounts have become so popular in the last decade.

What are the chief benefits of SMAs?

They don’t suffer from a lot of mutual fund flaws, like tax inefficiencies and hidden costs. You don’t have to worry about sneaky behaviors. With a separate account, since you have direct ownership of the securities, you know what’s in your portfolio 24/7.

And recently technology has made SMAs available for the mass affluent.

Right. Separate accounts have always been popular with the super-wealthy — you had to be super-wealthy to afford them.

Do you personally own any mutual funds?

I knew they were bad, so I’ve stayed away from them. But last year, for the first time in my life I purchased one. I plunked down $10,000 to buy a mutual fund because I felt that if I’m going to criticize them, I should know firsthand about all the headaches they cause. Before that, I had no choice but to have some mutual fund investments because of the defined contribution plan I’m in from when I was a finance professor. And I’ve got 529 accounts set up for my children’s college education that have mutual funds.

What do you think of ETFs?

They’ve become popular because people have been disgruntled with the lack of performance of professionally managed funds. But an ETF is only a partial solution because it’s a bundled product — you aren’t able to customize. This lack of customization creates tax inefficiencies. For example, customization is useful for tax-loss harvesting at the end of the year. With a separate account, you can just tick off the different securities that have done poorly and recognize those losses.

Any other ETF tax inefficiencies?

Yes. The cost basis that matters is when the ETF purchased the security and put it into the fund – not when the client purchased the ETF. So if a security is sold off, there might be capital gains taxes that have to be paid on returns – and the clients may not even have enjoyed the returns if they came into the ETF later on.

Anything else FAs should know about mutual funds?

It’s going to be trickier for advisors to recommend mutual funds [for retirement accounts] because of the [Department of Labor fiduciary standard] rule since they often have a vested interest in selling a particular class of fund [based on] how they’re compensated, such as [with] 12b-1 fees. So by recommending certain mutual funds, some advisors get a larger commission – and that’s always been kind of a conflict of interest.

In light of all the mutual fund negatives you point out, why do financial advisors widely recommend these funds to clients?

They don’t want to take time to look around and see what else is available. It strikes me as odd that they think the way to invest from 100 years ago is still the best way to invest today. Getting clients out of mutual funds would be doing them a tremendous service.

What attracted you about a career in finance?

My father was a finance professor. That’s where I got the idea to become one myself. I went into the financial field because I wanted to make a lot of money, but working for the SEC really changed me: I felt that I wanted to make the world a better place. Stock markets are like a modern-day miracle, where ordinary people have the ability to get rich. But the only way this can work is if there’s a fair playing field. So I’ve been a champion of trying to make sure we have one.

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