A bountiful harvest of mutual funds was produced in 2006. No, I’m not talking about the strong global markets that carried almost every stock mutual fund up this year — and more than half into double-digit territory. I’m talking about the bumper crop in new funds.
Many of these new funds are at a low fee — a good thing. These funds offer new ways to invest, an action that was previously unavailable to smaller investors. Armed with nothing more than an E*Trade account and a few thousand dollars, today’s fortunate fund investor can go long and short all sorts of indexes, sectors, styles, industry groups — even real estate, private equity, commodities, and currencies.
Mutual funds are investment companies: An investment advisor manages pools of money, following whatever strategy is described in the fund’s prospectus. Index funds are passively managed baskets, synched up to an index the fund tries to mimic. The fund promoters make money on management fees to run the fund.
In 2006, more funds went public (offered stock to individual investors for the first time) than actual companies that sell things. And this year was no slouch for new stock offerings either. We’re a country of finance, not widgets. Apparently there are more ways to package money to invest, than actual underlying companies to invest in.
Today the buzz is all about exchange traded funds (ETF). ETFs have the excitement and tradability of stocks, with the sensibility of diversified mutual funds — only cheaper. Or that’s the pitch anyway. ETFs are often based on indexes, though these days, the indexes are really just formula-driven lists of stocks created by the fund company — like “highest dividend stocks in the S&P500, equally weighted” or “healthcare stocks, ranked by market cap.” These days, we’re adding about a dozen new ETFs a month.
What we’re experiencing now is nothing short of amazing. There were thousands of funds launched in the 1990s. Eventually, the number of funds passed the number of stocks listed on the New York Stock Exchange. The crash of 2000 was supposed to lead to a great consolidation in the fund business, as previous crashes had done. Sure, some tech and Internet funds closed (near the bottom of course), but by and large, the fund business remained very much intact.
Today, including all the share classes created for various sales channels, there are thousands more funds than the bubble years. Investment company stocks - stocks of the advisors behind the mutual funds - have been among the stock market’s best performers in recent years. And why not, they collectively manage over $10 trillion.
I’ve got nothing against new mutual funds. In fact I’ve been covering them extensively since the last great fund-launching boom in 1999 on MAXfunds.com. Before that, I worked in the fund business launching funds. But all this opportunity might spell trouble for investors. That’s right; it’s bah humbug time.
There are two big problems with the new funds glut:
1) Investors tend to get into trouble with more targeted and risky investment choices. When you buy a more diversified fund, you can only get into so much hot water when say, tech or oil stocks tank. The more concentrated your investment, the greater your downside.
Of course, you also have a much greater upside. Unfortunately, most investors tend to buy after big runs have been made, then get burned in the eventual earth landing. Throughout most of recorded mutual fund history, the most volatile and focused funds have lost investors the most money as a percent of fund assets.
2) What is saleable is rarely a good idea. Investor optimism is like fertilizer for funds. The greatest boom in fund launches occurred before the crash of 1929, the Nifty Fifty wipeout and ensuing 1970s market decay. Far more funds launched in the 12 months before the 1987 crash than the 12 months after — and those launched post-crash tended to be safer bond funds. The late 1990s were among the biggest boom times for fund launches.
Goldman Sachs launched a pile of speculative closed-end funds (the ETFs of their day) in 1929. When questioned about the logic behind the new fund launches, a partner said, “Well, the people want them.” Indeed.
As an investor, you’d have to look pretty hard to find something fundamentally wrong today. The economy is strong, employment is great, inflation is under control, interest rates are low, corporate profits are at record levels, per capita wealth is at all time highs, home prices remain elevated, the most invested in stock index and the S&P 500 is still below record levels.
The number of new funds is probably the most frightening feature of this new “permanently high plateau” in the economy and stock market. There simply can’t be this many good ideas.
Jonas Max Ferris is a regular contributor on "Cashin' In" and is co-founder of MAXfunds.com.
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