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Mutual Funds Are for Suckers

By Dr. George Huang
Friday, July 17, 2009

More than 70% of funds underperform their benchmark every year. It's pathetic.
 
On average, an actively managed fund returns 2% less (after fees) than the index it's measured against. A $100,000 portfolio that compounds 10% per year will grow to $1.7 million in 30 years. The fund with a 2% drag? Just $1 million. That's a $700,000 difference.
 
Mutual funds disappoint for several reasons...
 
For starters, the compensation structure is flawed. Mutual fund managers get a slice of your investment (typically 1%-2%) every year, no matter how they perform. Because they're paid based on total assets under management, not performance, managers shift focus from returns to fundraising.
 
More important, mutual fund regulations meant to protect investors actually make matters worse. For example, some rules mandate diversification. So instead of owning his 10 favorite stocks, a mutual fund manager may be forced to own more than 100 stocks... and dilute returns in the process.
 
Rules can also force managers to sell winning stocks prematurely, as their increased presence in the portfolio violates the diversification mandate. Also size rules prohibit large-cap mutual funds from owning mid- or small-cap stocks, even if it's the best thing to do at the time.
 
Other rules prevent funds from buying companies in the midst of corporate restructuring or those temporarily losing money... or owning a stock that trades too few shares a day... or shorting stocks.
 
I could keep beating up on mutual funds. But my point is our hands aren't tied. And we can take full advantage of the mutual fund industry's cumbersome rules and poor performance. Burdened by heavy government regulation, clumsy mutual funds create lucrative market "glitches" for smart investors.
 
One of the most successful investors to recognize and take advantage of these loopholes is Joel Greenblatt... Greenblatt's hedge fund – Gotham Capital – generated 50% profits every year for a decade. Every dollar invested in Gotham back in 1984 turned into $52 when Greenblatt closed shop and returned all the money in 1994.
 
Greenblatt outlined his killer strategies in his top-selling book You Can Be a Stock Market Genius. His focus is "special situation" investing. In short, he buys stocks undergoing some sort of corporate reorganization – spinoffs, mergers, acquisitions, and bankruptcy restructuring. In other words, an event that creates massive price fluctuations... and prevents mutual funds from owning shares.
 
If you're interested in special-situation investing, I recommend starting with Greenblatt's excellent book. Then, take a hard look at Canadian-based biotech company QLT (QLTI).
 
Faced with steep competition for its flagship drug for eye disorders, QLT decided to liquidate all its non-core assets starting in 2008. But mutual funds holding the stock couldn't wait any longer. They had watched QLT shares drop from over $20 (in 2004) to below $5, a loss of 75%. Many were forced by their charters to dump their stock.
 
I figure about 90% of QLT's shares were held by growth and health care funds. When those investors sold out, the ensuing liquidation pushed QLT shares to $2. That's about 15% below QLT's net cash. But like I said, mutual funds are terrible investors...
 
QLT is in the best shape of its life. The company receives royalties from two marketed drugs, sold by European pharmas Sanofi-Aventis and Novartis. And the newly restructured company turned profitable again this year. With the mutual funds forced out of the shares, it's a perfect Greenblatt setup...
 
My FDA Report readers are up a couple points on the stock already. I expect we'll double our money before the end of the year.
 
Good investing,
 
George Huang




In The Daily Crux Recent Articles
Market Notes
Sharp reversal for natural gas... UNG rebounds 7.5% on lower-than-expected reserve stockpiles.
 
DIY lumber supplier Universal Forest leaps 18% to new high.
 
Blue chips litter the 3-month highs... 3M, Intel, Johnson & Johnson, Kraft, Coca Cola, Procter & Gamble are climbing.
 
Earnings today... Bank of America, Citigroup, General Electric, Mattel.
Market Watch
Symbol Price
Change
52-Wk
S&P 500 1221.53 +1.3% +10.1%
Oil 38.31 +1.4% -0.6%
Gold 138.07 +2.1% +16.3%
Silver 28.60 +2.4% +53.6%
US-Dollar 80.67 -0.8% +8.1%
Euro 1.32 +0.6% -12.1%
Volatility 18.01 -7.1% -19.8%
Gold Stocks 581.56 +3.0% +17.0%
10-Year Yield 3.02 +0.7% -10.7%

World ETFs
Symbol Price
Change
52-Wk
USA 122.89 +0.3% +11.3%
Canada 30.50 +0.2% +16.2%
Russia 21.94 +1.4% +18.1%
India 37.85 +0.3% +22.3%
Israel 16.69 +1.3% +10.8%
Japan 10.64 +0.6% +6.5%
Singapore 13.73 -1.1% +18.8%
Taiwan 14.78 +0.4% +19.2%
S. Korea 57.31 +1.3% +23.4%
S. Africa 71.87 +1.4% +28.2%
China 44.42 -1.4% -0.6%
Lat.America 53.17 +0.7% +8.4%

Sector ETFs
Symbol Price
Change
52-Wk
Oil Service 137.59 +1.0% +18.9%
Big Pharma 64.14 +0.0% -3.2%
Internet 72.07 -0.1% +23.4%
Semis 16.22 +1.2% +29.4%
Utilities 31.28 +0.2% +1.5%
Defense 18.52 +0.1% +10.6%
Nanotech 10.03 +0.4% +1.6%
Alt. Energy 10.08 +1.3% -3.3%
Water 18.49 +1.0% +14.5%
Insurance 16.14 +0.4% +21.1%
Biotech 20.54 -0.2% +28.1%
Retail 19.70 +0.3% +30.2%
Software 24.79 +0.8% +25.9%
Big Tech 53.87 +0.3% +22.7%
Construction 13.10 +0.9% +15.7%
Media 13.64 +0.5% +26.0%
Consumer Svcs 67.39 +0.2% +24.5%
Financials 55.04 +0.3% +7.4%
Health Care 64.30 +0.1% +2.0%
Industrials 63.54 +0.5% +21.0%
Basic Mat 74.35 +1.1% +25.3%
Real Estate 55.32 +0.1% +25.0%
Transportation 91.77 +0.7% +26.9%
Telecom 22.59 +0.5% +17.8%