The Taylor Frigon Advisor: The intermediary trap and the current bear market

October 2008 has come to a close, and it was one of the worst on record for the stock market.

Even worse, however, is the fact that during volatile times such as these, many investors themselves experience more damaging rates of return due to poor decisions. A recent article on the Morningstar website reports that, according to Morningstar's Market Intelligence research, investors have been selling their mutual fund investments in record numbers.

Morningstar reports that "a net amount of $49 billion left mutual funds in September alone. We've been tracking redemption data since January 2000, and that's the largest one-month outflow that we've seen to date. Yet, it looks like October is on pace to beat it."

As we have noted many times in the past, this type of behavior has led to the results found in the Dalbar studies which for many years have shown that over long periods of time, "the average investor earned significantly less than mutual fund performance reports would suggest."

In other words, the long-term track record of an investment vehicle is better than the track record of those who jump into it and jump out of it, especially because they often jump out of it at the worst times. The Dalbar studies have also demonstrated that "investors make most mistakes after downturns," and graphs from the 2000-2002 bear market support that assertion, such as those we posted in this previous piece.

This problem highlights a glaring deficiency in the current financial services industry, one that does a huge disservice to individual investors, whether they are small investors or very wealthy families. As we have pointed out, the data in these studies indicates that these well-documented investment mistakes are generally made by investors who are receiving professional advice from "financial advisors", "wealth managers" or "financial planners."

The Wall Street Journal today published an article entitled "No Place to Hide" that points out that, as bad as the returns have been year-to-date for the US market indexes, "The average international-stock fund is down 44.6% so far this year, according to Lipper, 10 percentage points worse than the average U.S.-stock fund." The article also correctly points out that "Following the advice of investment pros, mutual-fund investors had also moved heavily into overseas funds in the past few years."

As we explained in a whitepaper entitled "The Intermediary Tra p" that we published in February, 2008, the "investment pros" that the Journal is talking about in today's article were not deliberately trying to sabotage their clients' returns (far from it), but "rather out of good intentions which end up creating long-term damage."

In fact, we went on, "because these professional intermediaries have access to more performance data and more information about new management styles and investment trends, they may be even more prone to chasing performance or switching to a different form of investment than nonprofessionals would be."

This behavior is exactly what the Journal article chronicles when they point out that "Many investors may be tempted to make up for losses by jumping into whatever stock-fund category emerges as the next hot thing, as some were doing with commodities funds earlier this year -- before commodities prices plunged." How many of those investors who flocked into commodities funds when they were going up do you think did so on the advice of financial professionals?

Many nonprofessional investors would not have even known about the latest crop of commodities investment vehicles if they hadn't been introduced to them by the intermediaries. The fact that those intermediaries were "just trying to help" is little comfort to those who were burned by the collapse of commodities and international funds.

Compounding this problem is the fact that intermediaries, because they are not investment managers themselves, often use vehicles such as mutual funds in order to obtain investment management for their clients. As we pointed out in "Some drawbacks of mutual funds" back in May, the pooled nature of mutual funds comes with significant disadvantages. One of these comes when investors panic and sell during a serious bear market, creating a problem for the portfolio manager and for investors who are left in the fund (see the diagram above).

The Morningstar article cited earlier explains, funds typically do not have cash on hand for such mass redemptions so their managers are forced to sell into weak markets, and are prevented by lack of cash from buying even when bargains are plentiful. "If those redemptions force the fund manager to sell securities at lower prices, the investor who redeemed doesn't bear the cost. Rather, it is spread across the entire pool of investors still in the fund."

Clearly, these two problems are related -- the problem of investors selling that Dalbar has chronicled, and the drawbacks of mutual funds which are exacerbated by that selling, which Morningstar describes.

We have long advised investors to avoid the pitfalls of financial intermediaries, and (if possible) mutual funds as well. Sadly, as the recent articles from the Wall Street Journal and Morningstar indicate, the real dangers of such "intermediary" investing are most evident in a bear market environment.

For later posts dealing with this same topic, see also: